Financial markets

Buttonwood's notebook

Earnings growth forecasts

Burning a hole

Feb 9th 2011, 11:35 by Buttonwood

A COMMENT by Pensions Actuary on a recent post inspires me to nail one particular canard; that dividends are old-fashioned and today's more progressive companies reinvest their earnings for future growth.

My simple equation, known as the Gordon growth model, is that the initial dividend yield plus dividend growth, plus or minus any change in rating, equals the total return. Expressed in this way, there are no other sources of return; the capital gain flows from the dividend growth and the change in rating. Retained earnings are the device by which companies invest, and thus increase future dividends.

But what about the idea that companies have become more growth-oriented, retaining more of their earnings, and paying out less in dividends? As it happens, there is an excellent paper on this issue from 2002, written by Robert Arnott, a former editor of the Financial Analysts' Journal, and Cliff Asness, a hedge fund manager who co-founded AQR and was previously a quant fund manger at Goldman Sachs.

Their analysis produced a counter-intuitive result; future dividend growth rates are higher in periods when payout ratios are high (ie when a higher proportion of profits is paid to shareholders) and lower when payout ratios are low. That is because cash tends to burn a hole in the pocket of executives. As the authors write:

dividends might signal managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth.

Incidentally, in that previous post, I was being as optimistic as I could in getting future equity returns of 7.5%. But as a couple of commenters pointed out; the cyclically-adjusted price-earnings ratio is high (a sign that future returns will be low) and share option issuance often offsets buy-backs. The way that pension funds (and many companies) assess future returns is based on very wishful thinking.

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MJaga wrote:
Feb 9th 2011 4:12 GMT

A bird in hand is better than two in the bush?

jouris wrote:
Feb 10th 2011 1:28 GMT

It would be interesting to see a comparison of companies by country.

I'm thinking that the "cash tends to burn a hole in the pocket of executives" finding suggests (perhaps unfairly) that those were American executives. And they were showing the same poor ability to invest for the future that lots of Americans do in their personal finances. So it might be a cultural phenomena, rather than one common to all companies everywhere.

bampbs wrote:
Feb 10th 2011 2:57 GMT

"The way that pension funds (and many companies) assess future returns is based on very wishful thinking."

True. And all the rest base theirs on mere wishful thinking.

Feb 10th 2011 5:54 GMT

Thank you, Buttonwood, for the comments and quote.

I confess to worrying about the lack of dividends (discipline?) in the companies in which I invest. Chronically retained earnings feel like opportunity lost, not gained. Just don't tell that to the greater fool who shall one day relieve me of my shares.

Headline idea: "Canard in the Coal Mine"

Already used? Or useless?

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About Buttonwood's notebook

In this blog, our Buttonwood columnist grapples with the ever-changing financial markets and the motley crew who earn their living by attempting to master them.

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