The Myth of the Earnings Yield Essay written by Sam Vaknin Sam Vaknin's Psychology, Philosophy, Economics and Foreign Affairs Web Sites A 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 financial theories we employ in order to determine the value 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 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 stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies engage 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 likely 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 dividend...
