The Myth of the Earnings Yield

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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.

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:

That the fair “value” of a share is closely correlated to its market price;
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;
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.

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Fair Value of A Common Stock

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A lot of discussions have been devoted towards finding fair value of an investment. The goal of every investors is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of an investment reflect its earning power.
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A lot of discussions have been devoted towards finding fair value of an investment. The goal of every investors is to find undervalued investment and sell it when it reaches fair value. Admittedly, this is the hardest part of investing. So, what is fair value? Fair value is a point where the price of an investment reflect its earning power.

Fair value is relative and it depends on other factors beyond the investors’ control. In here, we will discuss on calculating fair value within our own boundary of control. In short, calculating fair value of an investment depends on the rate of return expected and the risk taken to achieve that return. Higher risk needs higher reward. It is quite simple.

So, what asset constitute lower risk investments? We can only compare. First thing that comes out of my mind is Certificate of Deposit (CD). You are guaranteed certain return (interest rate), if you can hold for a certain pre-determined time frame. You would never lose your principal at the end of the time frame.

The next low risk investment is Treasury Bond. This is the bond issued by the United States government, which is deemed to be safest in the world. There are certain risks associated with the small fluctuation in the bond price. However, if you held the bond until maturity, you are guaranteed certain rate of return. Your rate of return depends to certain extent on the price that you bought the bond at.

The next higher risk investment is buying common stock. This is what we are going to focus more here. It is considered higher risk than the two types of investments mentioned previously because you have a higher chance of losing money on your investments. Earlier, we established that higher risk needs higher reward. Therefore, stock investing requires a higher reward.

So, what does this have anything to do with fair value? Quite simply, the price of a common stock that we buy must gives us a higher annual return than bonds or CD. For example if a CD gives you a 3% return, treasury bonds give you a 4% return, then you would want your stock gives you a higher return of perhaps 6%.

What does it means for a stock to give investor a return of 6%? It never really say it, doesn’t it? You are partly right. While it is not explicitly shown, you can do a little digging and find out how much the return of your stock investment would be. For example, if your Certificate of Deposit (CD) gives you a 2% annual return, for $ 100 of investment, you would earn $ 2 every year. Let’s assume that you want your stock to give you a return of 6%, which is higher than CD or treasury bond. This implies for every $ 100 invested in common stock, it needs to give us a return of $ 6 annually.

Where can we get this information? You can get it on Yahoo! Finance or other financial publications. All we need to do is find the share price of a common stock and the profit per share (also known as earning per share) of that particular stock. Let’s use an example to illustrate my point. Magna International Inc. (MGA) is expected to post a profit of $ 6.95 per share for fiscal year 2005. Recently, the share is trading at $ 73.00. The annual return of buying Magna stock is therefore $6.95 divided by its share price $ 73.00. This gives us a return of 9.5%.

Will Magna continue to give investors a 9.5 % return year after year? It depends. If the stock price rises, Magna will return less than 9.5 % annually. What else? Well, Magna might not constantly produce the same amount of profit year after year. It might even produce a loss! So, you see, stock investing is inherently risky because there are two moving part in the equation. Price of the common stock and the profits produced by the company itself. That is the reason why investor need to aim for higher return when choosing their stock investment.

All right. So, let’s move on to the crucial thing in investing in common stock. What is the fair value of Magna stock assuming a constant profit of $ 6.95 per share? Personally, I assign fair value of a common stock to be at least 2% above the rate of Treasury bond. Please note that I am using the 10 year bond here. Recently, treasury bond can give us a 4 % return. Therefore, the fair value of Magna common stock is when it can give me a return of 6%

So, what is the fair value of Magna common stock in this case? For a profit of $ 6.95 per share, the fair value of Magna common stock is $115.80 per share. That’s right. At $ 115.80 per share, Magna common stock will return investors 6% annually. Having said that, we should never buy a common stock at fair value. Why? Because our investing purpose is to make money. If we buy stocks at fair value, then when do we profit from it? Do we expect to sell it when it is overvalued? Sure, it would be nice if we can do that all the time. But to be conservative, let’s not bank on our stocks reaching overvalued level.

There you go. I have explained how to calculate fair value in a common stock. Of course, the $ 6.95 per share profit figure is the expectation of profit compiled by Yahoo! Finance. It is not in any way an endorsement to buy Magna common stock. You should do your own calculation to verify that number.

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