The Myth of the Earnings Yield

Abstract

A very slender minority of firms administer dividends. This truism have radical implications. In the absence of dividends, the foundation of most - if not all - of the financial theories we use in order to determine the value of shares, is falsified. These theories trust on a few inexplicit and expressed assumptions:

That the (fundamental) "value" of a share is closely correlated (or even equal to) its market (stock exchange or transaction) price;

That terms motions (and volatility) are mostly random, though correlated to the (fundamental) "value" of the share (will always converge to that "value" in the long term);

That this cardinal "value" reacts to and reflects new information efficiently (old information is fully incorporated in it).

Investors are supposed to price reduction the watercourse of all hereafter income from the share (using one of a countless of possible rates - all hotly disputed). Only dividends represent meaningful income and since few companies engage in the statistical distribution of dividends, theorists were forced to deal with "expected" dividends rather than "paid out" ones. The best gauge of expected dividends is earnings. The higher the earnings - the more than likely and the higher the dividends. Even retained earnings can be regarded as postponed dividends. Retained earnings are re-invested, the investings generate earnings and, again, the likeliness and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a output - using the earnings output and other measures. It is as though these earnings WERE distributed and created a tax return - in other words, an income - to the investor.

The ground for the prolongation of this misnomer is that, according to all current theories of finance, in the absence of dividends - shares are worthless. If an investor is never likely to have income from his retentions - then his retentions are worthless. Capital additions - the other word word form of income from shareholding - is also driven by earnings but it makes not have in financial equations.

Yet, these theories and equations stand up in blunt direct contrast to market realities.

People make not purchase shares because they anticipate to have a watercourse of future income in the form of dividends. Everyone cognizes that dividends are fast becoming a thing of the past. Rather, investors purchase shares because they trust to sell them to other investors later at a higher price. In other words, investors make anticipate to recognize income from their shareholdings but in the word form of capital gains. The terms of a share reflects its discounted expected capital additions (the price reduction rate being its volatility) - NOT its discounted hereafter watercourse of income. The volatility of a share (and the statistical distribution of its prices), in turn, are a measurement of outlooks regarding the handiness of willing and able buyers (investors). Thus, the expected capital additions are comprised of a cardinal component (the expected discounted earnings) adjusted for volatility (the latter beingness a measurement of outlooks regarding the statistical distribution of handiness of willing and able buyers per given terms range). Earnings come up into the image merely as a yardstick, a calibrator, a benchmark figure. Capital additions are created when the value of the firm whose shares are traded increases. Such an addition is more than often than not correlated with the hereafter watercourse of income to the FIRM (NOT to the shareholder!!!). This strong correlativity is what binds earnings and capital additions together. It is a correlativity - which might bespeak causation and yet might not. But, in any case, that earnings are a good placeholder to capital additions is not disputable.

And this is why investors are obsessed by earnings figures. Not because higher earnings intend higher dividends now or at any point in the future. But because earnings are an first-class forecaster of the hereafter value of the firm and, thus, of expected capital gains. Put more than plainly: the higher the earnings, the higher the market evaluation of the firm, the bigger the willingness of investors to purchase the shares at a higher price, the higher the capital gains. Again, this may not be a causal concatenation but the correlativity is strong.

This is a philosophical displacement from "rational" measurements (such as cardinal analysis of hereafter income) to "irrational" 1s (the future value of share-ownership to assorted types of investors). It is a transition from an efficient market (all new information is immediately available to all rational investors and is incorporated in the terms of the share instantaneously) to an inefficient 1 (the most of import information is forever lacking or lacking altogether: how many investors wish to purchase the share at a given terms at a given moment).

An income driven market is "open" in the sense that it depends on newly acquired information and responds to it efficiently (it is highly liquid). But it is also "closed" because it is a nothing sum of money game, even in the absence of chemical mechanisms for merchandising it short. One investor's addition is another's loss and all investors are always hunting for deals (because what is a deal can be evaluated "objectively" and independent of the state of head of the players). The statistical distribution of additions and losings is pretty even. The general terms degree amplitudes around an anchor.

A capital additions driven market is "open" in the sense that it depends on new watercourses of capital (on new investors). As long as new money maintains pouring in, capital additions outlooks will be maintained and realized. But the amount of such as money is finite and, in this sense, the market is "closed". Upon the exhaustion of available beginnings of funding, the bubble be givens to explosion and the general terms degree implodes, without a floor. This is more than than commonly described as a "pyramid scheme" or, more politely, an "asset bubble". This is why portfolio theoretical accounts (CAPM and others) are improbable to work. Diversification is useless when shares and markets travel in bicycle-built-for-two (contagion) and they move in bicycle-built-for-two because they are all influenced by one critical factor - and only by one factor - the handiness of future buyers at given prices.