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CHAPTER SIXTEEN DIVIDENDS AND EARNINGS 1 STOCK VALUATION BASED ON EARNINGS • THE DIVIDEND vs. EARNINGS CONTROVERSY – How important is the dividend decision made by management? 2 THE DIVIDEND V EARNINGS CONTROVERSY • Miller & Modigliani (M&M) argue that the underlying source of value for a share is earnings 3 THE DIVIDEND V. EARNINGS CONTROVERSY • M&M: the dividend decision is relatively unimportant 4 THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • has two flows • the stream of expected earnings • the expected net investment required to produce such earnings 5 THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • earnings are exactly equal to dividends and investment E = D + I 6 THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • earnings are exactly equal to dividends and investment E = D + I unless E < D + I 7 THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • which implies the firm obtained additional funds such as from the sale of stocks 8 THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • ISSUING STOCK – rather than debt ( which increases the D/E ratio), stock allows greater dividends to the stockholders 9 THE DIVIDEND DECISION • WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF? 10 THE DIVIDEND DECISION • EXAMPLE: – Consider Mr. Jones who owns 1% of a firm A’s common stock – Assume the firm follows the policy E = D + I – then, Jones’ dividend = .01D 11 THE DIVIDEND DECISION • EXAMPLE: – Consider Mr. Jones who owns 1% of a firm A’s common stock – But: if the firm follows the other policy E < D + I Jones must invest additional funds to maintain his 1% ownership in Firm A 12 THE DIVIDEND DECISION • EXAMPLE: – Let F = the additional funding obtained by the firm E+F=D+I – then .01F is required. – Implication: the amount of the extra cash dividend is exactly offset by the amount Jones needs to spend to maintain his 1% ownership in Firm A. 13 THE DIVIDEND DECISION • EXAMPLE: – but if the firm follow the policy E>D+I Jones must sell back stock to the firm or else end up with more than 1% ownership – Key Idea: • No matter what the firm’s dividend policy, Jones is still able to spend the same amount on consumption 14 THE DIVIDEND DECISION • EARNINGS DETERMINE MARKET VALUE – the aggregate market value of equity is equal to • Present Value of expected earnings • less investment (E - I) – the size of the dividend is not important – market value of stock is independent of the dividend decision and – related to earnings prospects of the firm 15 DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY – most firms keep dollar amount of dividends constant over time – larger earnings may increase dividends 16 DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY – Lintner Model: • models behavior implied by a constant long-run target payout ratio of dividends 17 DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY – Lintner Model: • Let P = payout ratio goal of the firm • total dividends paid in year t is D = p*E where D is the target dividends in year t E is the amount of earnings annually 18 DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY – Lintner Model: • the larger the current earnings, the larger the change in dividends, but • the larger the previous period’s dividends, the smaller the change in dividends 19 THE INFORMATION CONTENT OF DIVIDENDS • DIVIDEND CHANGES MAY BE A SIGNALING DEVICE – Signaling • an increase means management is optimistic about future earnings • investors raise their earnings expectations 20 THE INFORMATION CONTENT OF DIVIDENDS • DIVIDEND CHANGES MAY BE A SIGNALING DEVICE – changes in dividends may be more important that the level of dividends decision 21 PRICE TO EARNINGS RATIOS • HISTORICAL RECORD – ratio varies individually on a year-to-year basis – general trend • for the S&P 500 both EPS and prices show general increases over time • EPS and prices do not parallel each other 22 PRICE TO EARNINGS RATIOS • HISTORICAL RECORD – Permanent and Transitory Components of Earnings • reported total earnings may have two components: – transitory: the increase or decrease is not repeated – permanent: means the change may be ongoing 23 PRICE TO EARNINGS RATIOS – transitory: the increase or decrease is not repeated • varies in size from negative to positive • leads to a range of different P/E ratios over time • not correlated to a stock’s intrinsic value 24 PRICE TO EARNINGS RATIOS – permanent: means the change may be ongoing • changes over time and investors revise their forecasts • leading to change in stock price • leading to change in the P/E ratio • therefore, the P/E ratio varies over time • correlated to the stock’s intrinsic value 25 PRICE TO EARNINGS RATIOS • permanent: means the change may be ongoing – over time P/E ratios tend to revert to an average ratio for the whole market 26 RELATIVE GROWTH RATES OF A FIRM’S EARNINGS • EARNINGS GROWTH RATES – Historically • no reliable predictor of future growth • annual reported earnings follow a random walk • quarterly earnings may have a seasonal component 27 EARNINGS ANNOUNCEMENTS AND PRICE CHANGES • ANNOUNCEMENTS – stock prices tend to correctly anticipate earnings announcements beforehand – prices react correctly but not fully afterward – prices continue to move in a direction similar to their initial reaction for several months afterward 28 EARNINGS ANNOUNCEMENTS AND PRICE CHANGES • ANNOUNCEMENTS – analysts do better than sophisticated mechanical models in forecasting – analysts tend to overestimate when forecasting 29