The Myth of the Earnings Yield

By Sam Vaknin

Author of "Malignant Self Love - Narcissism Revisited"

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 Hula-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:

1.. That the fair "value" of a share is closely correlated to its

market price;

2.. That price movements are mostly random, though somehow related

to the aforementioned "value" of the share. In other words, the

price of a security is supposed to converge with its fair "value" in

the long term;

3.. That the fair value responds to new information about the firm

and reflects it - though how efficiently is debatable. The strong

efficiency market hypothesis assumes that new information is fully

incorporated in prices instantaneously.

But how is the fair value to be determined?

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.

Why was this oxymoron - the "earnings yield" - perpetuated?

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.

Thus, financial market theories starkly contrast with market

realities.

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.

==============================================================

AUTHOR BIO (must be included with the article)

Sam Vaknin ( http://samvak.tripod.com ) is the author of Malignant

Self Love - Narcissism Revisited and After the Rain - How the West

Lost the East. He served as a columnist for Central Europe Review,

PopMatters, Bellaonline, and eBookWeb, a United Press International

(UPI) Senior Business Correspondent, and the editor of mental health

and Central East Europe categories in The Open Directory and

Suite101.

Until recently, he served as the Economic Advisor to the Government

of Macedonia.

Visit Sam's Web site at http://samvak.tripod.com

This article is free for republishing
Source: http://www.articlealley.com/article_5654_19.html