The Myth of the Earnings Yield

By: Sam Vaknin | Posted: 18th August 2005

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.

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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

About the Author

Occupation: Webmaster

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

Contact him at http://samvak.tripod.com

http://samvak.tripod.com

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Tags: earnings, profits, efficiency, dividends, collateral, sam vaknin, malignant self love, vogue