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CHAPTER SIXTEEN

CHAPTER SIXTEEN. DIVIDENDS AND EARNINGS. STOCK VALUATION BASED ON EARNINGS. THE DIVIDEND vs. EARNINGS CONTROVERSY How important is the dividend decision made by management?. THE DIVIDEND V EARNINGS CONTROVERSY.

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CHAPTER SIXTEEN

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  1. CHAPTER SIXTEEN DIVIDENDS AND EARNINGS

  2. STOCK VALUATION BASED ON EARNINGS • THE DIVIDEND vs. EARNINGS CONTROVERSY • How important is the dividend decision made by management?

  3. THE DIVIDEND V EARNINGS CONTROVERSY • Miller & Modigliani (M&M) argue that the underlying source of value for a share is earnings

  4. THE DIVIDEND V. EARNINGS CONTROVERSY • M&M: the dividend decision is relatively unimportant

  5. 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

  6. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • earnings are exactly equal to dividends and investment E = D + I

  7. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • earnings are exactly equal to dividends and investment E = D + I unless E < D + I

  8. THE DOLLAR AMOUNT OF A FIRM’S INVESTMENT • which implies the firm obtained additional funds such as from the sale of stocks

  9. 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

  10. THE DIVIDEND DECISION • WHAT LEVEL OF DIVIDENDS WILL MAKE THE CURRENT STOCKHOLDERS BETTER OFF?

  11. 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

  12. 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

  13. 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.

  14. 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

  15. 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

  16. DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY • most firms keep dollar amount of dividends constant over time • larger earnings may increase dividends

  17. DETERMINANTS OF DIVIDENDS • DIVIDEND POLICY • Lintner Model: • models behavior implied by a constant long-run target payout ratio of dividends

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. EARNINGS ANNOUNCEMENTS AND PRICE CHANGES • ANNOUNCEMENTS • analysts do better than sophisticated mechanical models in forecasting • analysts tend to overestimate when forecasting

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