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.