The Myth of the Earnings Yield

In American novels, well into the 1950's, one finds protagonists using the future stream of dividends emanating from their share holdings to send their kids to college or as collateral. Yet, dividends seemed to have gone the way of the hoolah hoop. Few companies distribute erratic and ever-declining dividends. The vast majority don't bother. The unfavorable tax treatment of distributed profits may have been the cause.

The dwindling of dividends has implications which are nothing short of revolutionary. Most of the financial theories we use to determine the value of shares were developed in the 1950's and 1960's, when dividends were in vogue. They invariably relied on a few implicit and explicit assumptions:

A discount rate is applied to the stream of all future income from the share - i.e., its dividends. What should this rate be is sometimes hotly disputed - but usually it is the coupon of "riskless" securities, such as treasury bonds. But since few companies distribute dividends - theoreticians and analysts are increasingly forced to deal with "expected" dividends rather than "paid out" or actual ones.

The best proxy for expected dividends is net earnings. The higher the earnings - the likelier and the higher the dividends. Thus, in a subtle cognitive dissonance, retained earnings - often plundered by rapacious managers - came to be regarded as some kind of deferred dividends.

The rationale is that retained earnings, once re-invested, generate additional earnings. Such a virtuous cycle increases the likelihood and size of future dividends. Even undistributed earnings, goes the refrain, provide a rate of return, or a yield - known as the earnings yield. The original meaning of the word "yield" - income realized by an investor - was undermined by this Newspeak.

According to all current theories of finance, in the absence of dividends - shares are worthless. The value of an investor's holdings is determined by the income he stands to receive from them. No income - no value. Of course, an investor can always sell his holdings to other investors and realize capital gains (or losses). But capital gains - though also driven by earnings hype - do not feature in financial models of stock valuation.

Faced with a dearth of dividends, market participants - and especially Wall Street firms - could obviously not live with the ensuing zero valuation of securities. They resorted to substituting future dividends - the outcome of capital accumulation and re-investment - for present ones. The myth was born.

No one buys shares because he expects to collect an uninterrupted and equiponderant stream of future income in the form of dividends. Even the most gullible novice knows that dividends are a mere apologue, a relic of the past. So why do investors buy shares? Because they hope to sell them to other investors later at a higher price.

While past investors looked to dividends to realize income from their shareholdings - present investors are more into capital gains. The market price of a share reflects its discounted expected capital gains, the discount rate being its volatility. It has little to do with its discounted future stream of dividends, as current financial theories teach us.

But, if so, why the volatility in share prices, i.e., why are share prices distributed? Surely, since, in liquid markets, there are always buyers - the price should stabilize around an equilibrium point.

It would seem that share prices incorporate expectations regarding the availability of willing and able buyers, i.e., of investors with sufficient liquidity. Such expectations are influenced by the price level - it is more difficult to find buyers at higher prices - by the general market sentiment, and by externalities and new information, including new information about earnings.

The capital gain anticipated by a rational investor takes into consideration both the expected discounted earnings of the firm and market volatility - the latter being a measure of the expected distribution of willing and able buyers at any given price. Still, if earnings are retained and not transmitted to the investor as dividends - why should they affect the price of the share, i.e., why should they alter the capital gain?

Earnings serve merely as a yardstick, a calibrator, a benchmark figure. Capital gains are, by definition, an increase in the market price of a security. Such an increase is more often than not correlated with the future stream of income to the firm - though not necessarily to the shareholder. Correlation does not always imply causation. Stronger earnings may not be the cause of the increase in the share price and the resulting capital gain. But whatever the relationship, there is no doubt that earnings are a good proxy to capital gains.

Hence investors' obsession with earnings figures. Higher earnings rarely translate into higher dividends. But earnings - if not fiddled - are an excellent predictor of the future value of the firm and, thus, of expected capital gains. Higher earnings and a higher market valuation of the firm make investors more willing to purchase the stock at a higher price - i.e., to pay a premium which translates into capital gains.

The fundamental determinant of future income from share holding was replaced by the expected value of share-ownership. It is a shift from an efficient market - where all new information is instantaneously available to all rational investors and is immediately incorporated in the price of the share - to an inefficient market where the most critical information is elusive: how many investors are willing and able to buy the share at a given price at a given moment.

A market driven by streams of income from holding securities is "open". It reacts efficiently to new information. But it is also "closed" because it is a zero sum game. One investor's gain is another's loss. The distribution of gains and losses in the long term is pretty even, i.e., random. The price level revolves around an anchor, supposedly the fair value.

A market driven by expected capital gains is also "open" in a way because, much like less reputable pyramid schemes, it depends on new capital and new investors. As long as new money keeps pouring in, capital gains expectations are maintained - though not necessarily realized.

But the amount of new money is finite and, in this sense, this kind of market is essentially a "closed" one. When sources of funding are exhausted, the bubble bursts and prices decline precipitously. This is commonly described as an "asset bubble".

This is why current investment portfolio models (like CAPM) are unlikely to work. Both shares and markets move in tandem (contagion) because they are exclusively swayed by the availability of future buyers at given prices. This renders diversification inefficacious. As long as considerations of "expected liquidity" do not constitute an explicit part of income-based models, the market will render them increasingly irrelevant.

Ross Perot's 'Crazy Aunt In The Attic' here involves a 4th assumption that isn't being touched with a ten-foot pole.

4) The price of a college education will increase at a rate determined by the actual value of the education itself which will not be too far above the overall CPI.

Obvioulsy, assumption 4 is decidedly false.

a) College education outlays are made primarily by the government rather than individuals.

b) Price is a function of purchasing power, as well as of supply and demand. Since the gov has a bigger wallet than the average Joe Smith, the gov can withstand a much higher prices.

c) Colleges, therefore, charge what the market can bear, rather than what their product would be valued at by the average Joe Smith.

Colleges are expensive for the same reason drugs and medical treatments are expensive. Because the government pays for them, without regard to the value that is actually garnered in return for the purchase.

To: Sam Vaknin

Some free advice, FWIW.

1) When posting articles from your website, either indicate the source is your website (as it in fact is in this post), or source the UPI version (as you named it) and post an additional link to your website for additional material. If you want hits, be honest about it. The mislabled sourcing detracts from your credibility.

2) On your website, lose the 'floral' background. It makes reading difficult, and personally, I wouldn't bother reading further, but in this instance I wanted to understand what your website was and why you labled it 'United Press International'. I see you claim (truely?) to be a reporter for UPI?

Lastly, a question. Are thse articles excerpts from your book?

Interesting article. Private schools catering to working professionals are all the rage these days. Their tuition rates are somewhere between in state and out of state tuition. This shows not only how much education is subsidized, but also why universities go after out of state and international students. The subsidization has led to what all subsidies lead to - oversupply, which is why a college degree is more of a milestone like a high school diploma used to be. More and more, experience trumps education, especially in a tight job market.

As far as earnings go, it's not just the amount of earnings relative to others, it's the rate of earnings growth, and the faster the better. And to take the next step, it's also the rate of acceleration in growth in earnings. This is why everyone should learn calculus.

"it's not just the amount of earnings relative to others, it's the rate of earnings growth"

That's right. Take Home Depot. Back when they had ten stores the stock was worth x. and their earnings were y. You could not use a present value of future dividends because you didn't know in ten years whether they would have twenty stores earning z million or a hundred stores earning zz million.

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