Essay on Future Dividends and Earnings Per Share: continued
Mr. Clendenin's Suggestion on Stock Valuation
What Is The Half-Life of a Corporation?
Although there have been many studies about long-term investment in stocks, most have involved inadequate proxies, such as biased, but well-known stock indices.
Where are the studies that provide answers to such questions as:
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If one were to choose one thousand stocks at random in 1900, how many would still be in existence in 2000?
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How many stocks from this random list would have paid dividends for twenty years? Thirty years? Eighty years? One hundred years?
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What would be the final value of this one thousand random stock portfolio in one hundred years, assuming a “buy and hold” strategy?
It may be that such studies have not been made because it would debunk the Common Stock Legend – something not in the interest of Wall Street – the likely source of financing for such research.
The question is how much should we discount the future?
However, such research would seem to be necessary if we seek a rational basis for estimates to plug into William’s formula.
Mr. Clendenin's suggestion that we discount the far future more than the near raises the question: how much more?
Common stock value before the 1960s involved more commonsense that in the last four decades of the century. The basic rule was to buy stocks at a price that produced a dividend yield greater than the yield on bonds of the same company.
This reasonable assumption was in vogue when the foundation for the Common Stock Legend was being laid, before the manipulations of the buyback era and the nonsense of the Efficient Market Hypothesis.
The Earnings-Dividends Switcheroo
In the last quarter of the twentieth century, corporate earnings became more important among the Wall Street crowd than dividends.
Many have even committed the mortal sin of substituting earnings for dividends in John Burr Williams’ formula, thereby multiplying stock values to absurd levels.
Others have gone even further beyond the pale and instead of using the investor’s expected return, have switched to inappropriate substitutes, such as the interest rate on short-term Treasury bonds.
John Burr Williams's formula is often misused
When fuzzy thinking of this order is published by famous economists at top universities, Mr. Lesser Fool has an excuse, if not reason, to accept the Efficient Market Hypothesis and to believe that market price always equals intrinsic value.
There is, of course, a big difference between earnings and dividends.
The average investor cannot spend corporate earnings, as he may spend dividends. Earnings are an accounting concept, while dividends are cash in the bank.
The small investor cannot reinvest earnings to achieve compounded results as he might dividends.
Audited earnings refer to something that happened in the past. Projected earnings refer to something that may happen in the future.
On a given day, most companies do not know what current earnings are, since the accounts of a company are closed only quarterly. Besides, although accounting has standards, these are far from rigid.
Two identical companies may present earnings that vary by thirty percent, following the same code of accounting principles.
Economists, politicians, and many Wall Street pundits often think that earnings reports are hard numbers, like the price of gold, but they are mistaken.
The Illusion of Earnings Per Share
The illustration serves to remind us of the stark difference between earnings and dividends.
Earnings are often illusionary, while dividends are real and tangible.
We need to remember Lewis Carroll’s phrase about “Jam yesterday, jam tomorrow, but never jam today” when we substitute earnings for dividends.
A wise investor will not accept earnings for dividends, unless he controls the company
Earnings are of interest to investors because they signal whether a company may continue to pay dividends.
A firm that runs at a loss will usually suspend dividends. Earnings that are increasing may signal larger dividends in the future.
It is useful to compare earnings to dividends to judge the capacity of a company to pay dividends.
However, a wise investor will not accept earnings for dividends, unless he controls the company.
Many articles and books have been written that describe how earnings may vary.
The small investor will never be able to spend earnings unless they are paid to him in the form of dividends.
Here are some reasons why earnings are a weak reed on which to build a retirement plan:
Uncertain Standards. Accounting standards are flexible, allowing corporate executives to present financial reports that sometimes differ by as much as thirty percent, while still following the rules that CPAs devise.
A minority shareholders will never spend earning that are not paid as dividends
Cheating. Earnings are usually not audited for fraud or defalcations. Normal auditing practices do not include a complete, forensic review of a company and its employees. The auditors accept the reports presented to them by management, with only spot checking. Management may be dishonest.
Irrelevance. Earnings show what has happened in the past. By the time an investor receives an auditor’s report, the situation has changed. This may not be important for simple, stable businesses, like managing the city water works, but in complex, high-technology enterprises, with active trading of assets and worldwide operations, the reported earnings may be gravely misleading as to the current situation.
The Wrong Yardstick. Accounting practices were designed to check single companies and their direct subsidiaries.
Modern businesses, however, have changed into complex, interrelated groups of enterprises.
When a public company is controlled by a holding company with other interests, the holding company executives may shift earnings from one subsidiary to another, without detection by auditors of the public company.
For example, Company Alpha (a public company) and Company Beta (a private company) are controlled by a single investor who sells products of both companies together in a package, under-pricing products of Alpha and over-pricing products of Beta.
This effectively transfers profits from Alpha to Beta. Some groups are made up of hundreds of firms in a tangle of ownership, public and private, that confounds ordinary accounting practices.
When ownership is traced through multiple offshore holding companies, the scope of the traditional audit is inadequate.
Measuring the Unknowable. Many large public companies are too complex to be understood by anyone.
With hundreds of units, tens of thousands of accounts, dozens of foreign jurisdictions, and myriad, non-standardized agreements, including derivatives and contracts with contingent risks, earnings shown in an audited report under current accounting practices are of dubious utility.
In large companies, the actions of a single employee out of thousands may result in liabilities that not only wipe out a year’s earnings, but plunge the company into bankruptcy, as was the case with Barings.
Accounting standards do not call for reserves for such contingencies, because these standards were devised generations ago, when business was simpler.
Scandals at Enron, WorldCom, and Arthur Andersen have caused many to understand there are problems in accounting practices and that financial statements should be accepted with reservation.
Nevertheless, Mr. Lesser Fool, even after the crash of 2000-2001, still values earnings – especially changes in earnings – and is willing to ignore dividends.
Stocks zoom up and down as earnings reports are published, although the companies pay no dividends, nor plan to do so.
What Our Great Grandfathers Knew
Despite high-speed computers and ever-more sophisticated accounting techniques, the simple truth is that we know no more about the future than in the time of Sophocles.
If there is any criticism to be made of Mr. Clendenin's suggestion, it is that he may have been too timid in discounting the future.
Certainly he did not foresee that companies would eliminate dividends entirely or that investors would gladly accept the illusion of earnings in place of hard cash.
If commonsense returns to the stock market, it could be that investors will remember the wisdom of their great grandfathers and demand dividend yields on equities that exceed those on bonds, acknowledging the greater risk, uncertainty, and lesser legal claim on cash returns.
