In American novels, well into
1950's, one finds protagonists using future stream of dividends emanating from their share holdings to send their kids to college or as collateral. Yet, dividends seemed to have gone way of 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 cause.The dwindling of dividends has implications which are nothing short of revolutionary. Most of financial theories we use to determine value of shares were developed in 1950's and 1960's, when dividends were in vogue. They invariably relied on a few implicit and explicit assumptions:
That fair "value" of a share is closely correlated to its market price; That price movements are mostly random, though somehow related to aforementioned "value" of share. In other words, price of a security is supposed to converge with its fair "value" in long term; That fair value responds to new information about 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 fair value to be determined?
A discount rate is applied to stream of all future income from share - i.e., its dividends. What should this rate be is sometimes hotly disputed - but usually it is 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 earnings - likelier and higher 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 likelihood and size of future dividends. Even undistributed earnings, goes refrain, provide a rate of return, or a yield - known as earnings yield. The original meaning of word "yield" - income realized by an investor - was undermined by this Newspeak.
Why was this oxymoron - "earnings yield" - perpetuated?
According to all current theories of finance, in absence of dividends - shares are worthless. The value of an investor's holdings is determined by 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 ensuing zero valuation of securities. They resorted to substituting future dividends - 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 form of dividends. Even most gullible novice knows that dividends are a mere apologue, a relic of 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, discount rate being its volatility. It has little to do with its discounted future stream of dividends, as current financial theories teach us.
