Adherents of the “dividends-are-good” school sometimes point to the fact that stocks with high
yields tend to have above-average price–earnings multiples. Is this evidence convincing? Critically
discuss this statement
Answers
Answer:
donno...
Explanation:
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Answer:
Explanation:
It is true that researchers have been consistent in finding a positive association between price-earnings multiples and payout ratios. But simple tests like this one do not isolate the effects of dividend policy, so the evidence is not convincing.
Suppose that King Coal Company, which customarily distributes half its earnings, suffers a strike that cuts earnings in half. The setback is regarded as temporary, however, so management maintains the normal dividend. The payout ratio for that year turns out to be 100 percent, not 50 percent.
The temporary earnings drop also affects King Coal’s price-earnings ratio. The stock price may drop because of this year’s disappointing earnings, but it does not drop to one-half its pre-strike value. Investors recognize the strike as temporary, and the ratio of price to this year’s earnings increases. Thus, King Coal’s labor troubles create both a high payout ratio and a high price-earnings ratio. In other words, they create a spurious association between dividend policy and market value. The same thing happens whenever a firm encounters temporary good fortune, or whenever reported earnings underestimate or overestimate the true long-run earnings on which both dividends and stock prices are based.
A second source of error is omission of other factors affecting both the firm’s dividend policy and its market valuation. For example, we know that firms seek to maintain stable dividend rates. Companies whose prospects are uncertain therefore tend to be conservative in their dividend policies. Investors are also likely to be concerned about such uncertainty, so that the stocks of such companies are likely to sell at low multiples. Again, the result is an association between the price of the stock and the payout ratio, but it stems from the common association with risk and not from a market preference for dividends.
Another reason that earnings multiples may be different for high-payout and low-payout stocks is that the two groups may have different growth prospects. Suppose, as has sometimes been suggested, that management is careless in the use of retained earnings but exercises appropriately stringent criteria when spending external funds. Under such circumstances, investors would be correct to value stocks of high-payout firms more highly. But the reason would be that the companies have different investment policies. It would not reflect a preference for high dividends as such, and no company could achieve a lasting improvement in its market value simply by increasing its payout ratio.