The Myth of the Earnings Yield :: GCSE Business Marketing Coursework

The Myth of the Earnings YieldEssay written by Sam VakninSam Vaknins Psychology, Philosophy, Economics and Foreign Affairs Web SitesA very slim minority of firms distribute dividends. This truism has revolutionary implications. In the absence of dividends, the foundation of most - if not all - of the pecuniary theories we employ in order to determine the look on of shares, is falsified. These theories rely on a few implicit and explicit assumptions (a) That the (fundamental) value of a share is closely correlated (or even up equal to) its market (stock exchange or transaction) price (b) That price movements (and volatility) are mostly random, though correlated to the (fundamental) value of the share (will always converge to that value in the long term) (c) That this fundamental value responds to and reflects new information efficiently (old information is fully incorporated in it) Investors are supposed to discount the rate of flow of all future income from the sh are (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies take on in the distribution of dividends, theoreticians 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 in all likelihood and the higher the dividends. Even retained earnings can be regarded as deferred dividends. Retained earnings are re-invested, the investments generate earnings and, again, the likelihood and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a yield - using the earnings yield and other measures. It is as though these earnings WERE distributed and created a RETURN - in other words, an income - to the investor. The reason for the perpetuation of this misnomer is that, according to all current theories of finance, in the absence of divid ends - shares are worthless. If an investor is never likely to receive income from his holdings - then his holdings are worthless. Capital gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations. Yet, these theories and equations stand in stark contrast to market realities. People do not buy shares because they expect to receive a stream of future income in the form of dividends.