Financial Markets (2008)

ECON 252 (2008) - Lecture 11 - Stocks

Chapter 1. Introduction [00:00:00]

Professor Robert Shiller: I believe that we still have on, for Friday, Stephen Schwarzman. He said he would do it. I always worry about people who have such important businesses because some big deal may become in crisis or something; people like that have trouble sometimes adhering to a schedule. As far as I know we’re getting him, so I hope that you will all be able to come this Friday, here, at the usual time. If there’s any problem with his appearing I will email you.

As you know, Stephen Schwarzman is a graduate of Yale College and he’s one of the great stories of our century. He created just about the biggest private equity firm from scratch in 1985 and I guess they just went public and they have a huge market cap. They’re comparable to one of the biggest old line investment banks in New York. He just — he and Peter Peterson — just created it so I think it will be very interesting to hear him. Again, you’ll have a chance to question him about what he’s done. I put on the reading list The New Yorker article that’s out right now. Well actually, I guess it came out a couple of weeks ago, but it’s up on our syllabus. I think I might want to take it down before he comes. I’m going to turn — I’m going to reflect on this because he may not be pleased with the article. It’s a very hard-hitting critical article. He had to be a tough businessman to arrive where he is. The New Yorker article talks about the price of his condo — or co-op — in New York, which set some record, and so they tell things like that.

I was just yesterday in London and people like to gossip about things like that. The limo driver was driving me to the airport and was pointing out the scenes in London. He said, you know that building? Some Arab Sheikh just paid one hundred million pounds for that apartment — that penthouse apartment — in that building and the same Sheikh is ordering a Airbus for his — one of these big Airbus airplanes — for his personal plane and he’s having it plated with gold leaf. Did you hear this story? Does anyone — is this true? This limo driver told me this yesterday; he said it’s going to cost him five hundred million pounds or something like that to do this. These are gossip. The real substance is what the man does — or woman does — for the world.

So, I gleaned here a list of some of the charities that — Stephen Schwarzman is a major philanthropist. He set up something called The Blackstone Foundation from the Blackstone Group and he’s a major donor or collaborator with the Frick Collection, The Whitney Museum, Phoenix House, The Red Cross, The Inner City Scholarship Fund, New York City Outward Bound, and the Asia Society. I think that’s the real thing we should talk about, not the size of his penthouse. So, I might try to find a more even-handed account and put that up on the website. Incidentally, there’s sort of a resemblance between him and David Swensen in the–well, first of all, they’re both phenomenally successful, but they both are emphasizing alternative investments. They’re not straight-laced old-fashioned; they’re willing to take experiments. I think he should be very interesting; that’s Friday at 9.

Chapter 2. The Corporation as a “Person” [00:04:24]

I want to talk about the stock market today and I thought I would keep it more or less basic because I think — I want to emphasize basic concepts. A lot I’m going to talk about is Modigliani-Miller but I’m not going to get too deep into it, maybe in your review sections you can get more technical. I’m going to just talk about it in the very intuitive, direct terms. What are stocks? I think the idea of a stock must have been invented independently at many times in history. The word “shares” is the fundamental word. Suppose you are starting a business with somebody — it could be at any time in history — Babylonia or something — this must have happened. A group of people starts a business and they say, let’s divide up the proceeds. That’s very direct, isn’t it? If we’re all working together we divide up the proceeds. That means we’re allocating shares. Now, I don’t know how far back it goes but it must be that in ancient times some people would say, all right you’re going to be doing more work or you’re contributing more to this enterprise, we’ll give you a bigger share of the profits. That’s so basic, it must have happened a million times and that’s the basic idea of the stock market. All it is is that we’ve got it much more high-flown and much more legalized than — the basic idea is that you have to have shares in something — a business — and the idea goes back clearly to ancient Rome.

Let’s consider a business as sort of a person who is owned, like a slave, who is owned by other people. In law, the word “person” doesn’t mean what you think it means. There’s — in law, a “natural person” is you and me; people, real flesh and blood individuals are called natural persons. But when we say “person,” it also — that’s more general — it also includes corporation. The word “corporation” comes from the Latin, corpus, meaning body, so it’s an embodiment. We create an entity that, in the eyes of the law, is like an individual. It may be owned by other individuals but it has its own rights and responsibilities as if it were a person. In ancient Rome, corporations were called publicani — that’s Latin; the publicani were companies like we have today. According to the research of Ulrike Malmendier at Stanford, she thinks that the stock market in ancient Rome was done on the street — on the Roman Forum — and she can tell you where. When you go to Rome, you can walk and see what’s left of their stock market. It never flourished really until relatively modern times.

The idea, of course, is that we have a legal entity — a corporation — that issues shares that are either given to people or purchased by people and the idea is that shares represent contributions. You give shares to someone who is contributing to the enterprise. You can — when you set up a corporation there are different kinds of relationships that people might have with a corporation. One of them is as a shareholder and the shareholder gets a share — is entitled to a share — of the profits. There are also employees who get wages and that’s very different. They have a labor contract that specifies how much they will get. Then you have debtors and other people with other relationships.

The fundamental one is the shareholder because the shareholder owns the corporation. As it’s evolved in modern times, the corporation has a charter or bylaws. When you create a corporation you write up a contract, which specifies the rules of the corporation; it’s like a constitution for the corporation. Also, the law of the state in which the corporation is chartered also puts restrictions on what can be in the bylaws. Notably, it’s typically required that it’s one share, one vote and that there’s a — it would be also required that there be an annual meeting — at least once a year, a shareholder meeting — and then the shareholders can vote on relevant issues.

One of the most important issues then is to elect a board of directors. The state law probably requires that a corporation have a board of directors, but it’s also something that can be defined at the time that you create the corporation in the bylaws. It’s not something you can do just whatever you want. State law has requirements for the board of directors and — I’m just going to talk in very basic terms. The usual structure is one shareholder, one vote. At the annual meeting, the shareholders can come and elect a board and the board then is in charge of the company. The board hires the president or chief executive officer and other top officers of the company and they serve as employees of the board. The theory is that the shareholders are in control because they elect the board and the board hires the president and it’s democratic. I’m going to come back to it; it doesn’t always work out as perfectly as you want.

Now there’s basically–there are important distinctions between two kinds of corporations. There’s for-profit and non-profit. I’ve been describing a for-profit corporation, which is the usual variety. Non-profit corporations will also have a board of directors but they will not have any shareholders. There’s a fundamental difference in the charter and the way the government reacts to them. The non-profit organization or corporation is set up to advance some cause and it is not owned by anyone. The share price, you could say, is identically zero. Actually, you can’t say what the share price is because there are zero shares and they have a zero price, so the value of the price per share is zero over zero and you can’t define it. Yale University is a non-profit corporation; the price of a share in Yale University is undefined — it’s zero over zero. It has a board that runs it, but the board is not liable to shareholder vote. Well actually, we have some voting among alumni I guess, but it’s not a for-profit corporation. I’m going to be talking about for-profit.

Now, the critical thing to understand about a corporation is that in order to value a share in a corporation you absolutely have to know the number of shares outstanding. If I own one thousand shares in a company, what does that mean? It doesn’t mean anything until you know how many shares are outstanding because if I own one thousand shares and then you look it up and find out how many shares are outstanding — there are one thousand — you say, hey I own the whole company. It’s mine if I own one thousand shares and there are one thousand outstanding. What if you own one thousand shares and there are ten million outstanding? Well, then that means that you own one ten-thousandth of the company. Did I divide right? That’s a very important lesson to keep in mind. People don’t usually know how many shares are outstanding in the company that they invest in. That’s because, in a sense, they’re trusting to analysts. Ultimately, analysts are supposed to keep track of this. When they look at the price of a company, how do we know whether the price at which you’re buying is reasonable? They must be looking at some measure of the value of the company and dividing by the number of shares and then that gives them some idea of what the share is worth. But it’s absolutely essential — so the shares only mean something as a relation to their total number of shares.

Chapter 3. Shares, Dilutions, and Stock Dividends [00:14:02]

Companies routinely do what are called “splits.” They may do a two-for-one split; that means, if you held one thousand shares you get a letter saying, congratulations you now own two thousand shares. Don’t be too jubilant because when they do a split they do it to every single shareholder. So, you now have two thousand shares, but now there are twenty million shares outstanding in the company so the ratio is unchanged. You might ask, well why do they do splits? Well, it’s just to keep the numbers — there’s actually not a very good reason to do splits. There’s no reason not to do splits either because it’s just changing the units of measurement. But typically, in the United States, they do splits to keep the price of a share somewhere in the $20 to $40 range; there’s interesting literature on why they do that. Maybe it’s a tradition, maybe it’s to keep the value kind of in a familiar range or a small — they don’t want them to get too expensive because people can’t — small investors can’t afford them anymore. Who knows, but the point is it’s different in different countries. So the total number of shares is almost — the tendency to do splits is a cultural thing; it’s of no real significance.

Warren Buffett doesn’t do splits with his Berkshire Hathaway and there are other companies that — I guess Google doesn’t do splits, isn’t that right? Is that right or are you saying no? Actually, I don’t remember, but they haven’t done one yet. What is the price per share, do you know? This is getting a little high — $550 a share is kind of high because most people will buy — this is part of our tradition. Most people will buy shares in what’s called “round blocks,” that’s a hundred shares. So, if it’s $550, that makes $55,000 for a one round lot. I can’t multiply while I’m standing up. Most companies do splits because that might close the — you might have been thinking about investing in Google but you could still — you could just say, I want to buy ten shares or five shares and the broker will do it for you, but they might charge a higher commission. That’s the lesson.

There’s a term — I should write some of my terms down — a very important term in finance and that’s “dilution.” If the company increases the number of shares through a split that is not dilution because it doesn’t really mean anything. When you do a split, you’re changing the number of shares for everybody, so it can have no effect on the ratio for anybody; it’s just purely appearance. Dilution occurs when the company changes the number of shares asymmetrically — not changing it for everybody.

The typical example of dilution is: the board of directors has hired a CEO for the company and they want to motivate the CEO. They can pay the CEO a salary or they can give shares to the CEO — that’s quite standard because they feel that that makes the CEO a shareholder. It’s like another form of compensation and that compensation might have different attractiveness, so they give the person a package — both a salary and some shares. You see, if they give the — if they merely give shares to the CEO without increasing your shares, then you are being diluted because it’s raising the total and it’s reducing the ratio. Now, if a company sells shares, it issues new shares — it can do that at any time. When you start a company you might have had — maybe when Peter Peterson and Stephen Schwarzman founded The Blackstone Group they gave each of them five hundred shares — I’m just making that up — but obviously there’s going to be more shareholders as time comes in. One thing that people can do to get in is to buy shares. If the company issues new shares by selling them to the public, it’s not obviously dilution. Of course it’s lowering your share of the company, but offsetting this is that the company is taking in money from the person who bought the shares and so it doesn’t dilute you. Well, you could say it dilutes it but it doesn’t lower the price of your investment, in general. It could, depending on a lot of factors. Dilution occurs — the term specifically refers to changes in a number of shares that affect, adversely, existing shareholders.

Another common term is a “stock dividend.” Well first of all, I should talk about dividends. The stock market — I was going to talk about stock dividends, but I better talk about dividends first. In for-profit companies, people are investing in the company for profit. How do they get the profit? Well, the company — the board of directors — decides if and when to pay dividends to the shareholders and then the law of the state would say that they must treat them all equally. They made some money and now they want to take it out and spend it. They have to do it equally to all shareholders; that’s called paying a dividend. They can do it on rare occasions, or they can do it whenever they feel like it, or they can do it regularly; it’s often done quarterly. When I set up a company — Case Shiller Weiss, Inc. — typical of young start up companies, we didn’t pay a dividend. We gave shares to almost all of our employees as part of their compensation and we hoped that would motivate them and make them feel a part of the company but we never paid them a dividend. I remember one time I was talking to our CEO and he said, you know maybe we should pay at least one dividend because our employees are forgetting that they own these shares. So, we paid one dividend and I don’t know how much excitement it generated, but that’s the —

Student: Does this mean that share price will drop by $2 after a $2 dividend? Immediately after the payout dividend, the share — the price of the share should go down, right?

Professor Robert Shiller: Yes, he’s asking after a firm pays a dividend that should lower the — you were asking whether it should lower the price of a share. Yes, you are absolutely right. If the company pays out money, the value of the company should have just gone down by the amount they paid out, but the number of shares hasn’t changed. That means that the price of each share should decline by the amount they paid out divided by the number of shares. There’s a term for that — they call it going ex-dividend. So the company — it used to be you could look on — you can still see this. Some of these are still listed on The New York Stock Exchange page; on the day that a stock goes ex-dividend, they’ll have a little “x” by its price. The reason they put that there is so that people don’t get alarmed. A lot of people watch the price of their share everyday — some people get neurotic about it — and then suddenly it drops by $2 a share and they say, oh my God I’m worried. They call up their broker and say, what’s wrong? Then the broker has to explain, no didn’t you see the “x” there? It just went ex-dividend, so it doesn’t mean anything.

The “ex-dividend date” is not the date that you actually received the dividend, but it’s called the ex-dividend date, which the company decides on that date anyone who was a stockholder of record gets the dividend and the guy after that, you don’t get that dividend. That’s an important — this really does happen, stocks really do drop in price on ex-dividend date. Now incidentally, that’s an interesting question that you bring up, because — should I pay any attention to dividend dates as an investor? The answer is generally not because if you buy the stock before it goes ex-dividend, you get — you have to pay a higher price, but you get the dividend. If you wait until the next day, you pay a lower price but you don’t get the dividend. Unless there are some tax effects, which might matter — and taxes always complicate things — but disregarding tax effects, it doesn’t matter which you do. In fact, there’s a rule, FINRA, which licenses stockbrokers, tells their people, you must not sell dividends; they’re referring to a bad practice that some unscrupulous stockbrokers occasionally do. They’ll tell someone, hurry up and buy this stock because it’s going to go ex-dividend. If you buy it today — if you wait, you won’t get the dividend. That’s misleading because it really doesn’t matter when you buy the stock, so you’re not supposed to, as a broker, sell dividends.

That doesn’t mean dividends don’t matter. Ultimately, they’re a reason why you own a stock. This gets back — People are accustomed to getting dividend checks in the mail. If you own stock — we don’t get them in the mail anymore because you own it through some brokerage account and you get it on a website. You used to get checks in the mail; now you go on a website and you’ll see that your dividends are credited to your account, but money is growing in your account as companies pay out dividends.

I was going to talk about a stock dividend and I started to do that. Sometimes companies will announce that they are paying not a cash dividend, but they’re paying a stock dividend. They’ll say, we are pleased to announce that we are paying a dividend in new shares issued today by the company equal to 5% of your existing shares — so it’s a 5% dividend — congratulations. Is that a good thing? How excited should you be to get the letter saying your company has paid you a stock dividend? Any ideas on that? Well, you should be absolutely unexcited because it doesn’t mean anything; if they were giving you extra shares and just you alone, that would be great — that would be good. The whole essence of a stock dividend is that they’re paying it to every shareholder in the same proportion, so every one hundred shares becomes one hundred and five shares; so you know that that has no meaning to me. All that matters is the ratio: how many shares I own divided by the number of shares outstanding. If they both go up by the same proportion, then numerator and denominator go up by the same amount, so there’s no change.

Then you might ask, why in the world do companies issue stock dividends anyway, what’s the point? Are they trying to confuse or fool somebody? Well, there are different views on that. One of them is yes, they are trying to confuse and fool somebody. If they don’t have money to pay the dividend they can always do a stock dividend. On the other hand, some people say, well that would backfire. If they’re going to pay stock dividends and try to fool us, what’s going to happen? The price of a share is going to fall on that day. When you pay out stock dividends you would think that now there are more shares, everyone divides by the larger number of shares, and the value of the company goes down; it’s not going to work to pay a stock dividend. So, the more enlightened view is, corporations only pay a stock dividend when they have some good news to announce. Typically, they’ll write a letter saying, congratulations we have great news! We have some new breakthrough and in celebration of this we’re going to pay everyone a 5% stock dividend. Now, they are hoping that the price doesn’t fall because they’re announcing it with news and, in a sense, issuing the stock dividend is just a way to make it dramatic.

Now incidentally, in a for-profit corporation — this is how to understand this, this is a concept that is enshrined in law. In a for-profit corporation, the purpose of the entity is defined as profit for the shareholders. Now, in some countries and in some jurisdictions the law might not be entirely clear on that; they might say there are other stakeholders. But, in the purest form — and this is the form that we have in the United States — the company exists for the shareholders. They’re the ones — there are other people who have contracts with the company, like the employees, but the employees are not shareholders; they are receiving salary or something else. The important thing for the corporation is to live up to any promises it made. It has to live up to its promises. The purpose of the corporation is the shareholders. This is a capitalist idea that might sometimes sound wrong. You might say, why should a company exist for the shareholders? Well, the concept here is that it’s a good business model. People do need money and they go into business to make money; so let’s make it clear, that’s what the company is going to do. It has to behave in an honorable way for everyone; it has to live up to its contract. But the company generally doesn’t give to charity; it doesn’t contribute to political campaigns; it shouldn’t be, ideally, doing any of those things. It should be trying to get money back to the shareholders.

If you ever serve on a board of directors — this is the thing that I want you to remember because many of you will serve on boards of directors. When you sign on to a job on the board, you are signing on to a solemn responsibility and that responsibility is to treat all shareholders equally and fairly and make money for them. Then you’re not supposed to ever do anything that’s not honest or not living up to contracts, but your purpose is only one purpose: it’s the shareholder. When you serve on a board, you are in a fiduciary role; you are there to protect shareholders and that’s the concept. It’s for-profit and the theory that we have in capitalist countries is that this is a good model. There are non-profits, fine, but we — a lot of the stuff that has to be done for an economy is only going to get done through for-profit corporations. So let’s make it clear — let’s make it unambiguous — people who are on boards or are managers of these companies, they can give their personal money to charities but they themselves are obligated to make money. It’s not a vice. This is the concept that is in the law and the reason we have it in the law is that it works to produce prosperity and to produce the things we need, like clothes, medical service, homes, whatever. So that’s why we do it and there’s no shame in pursuing profits and getting it out to your shareholders.

Chapter 4. Distinguishing Earnings and Dividends, and Getting Money Out of Companies [00:31:26]

Now ultimately, the purpose of investing in a share is to get the dividends; that’s the whole named purpose of the corporation. I might add though that there are other ways that — I may have said that too narrowly. Traditionally, you buy stocks to get dividends; that’s the reason. I want to be careful about qualifying that. First of all, a lot of people don’t seem to even grasp that basic point that you buy stocks for the dividends. A lot of people think, I will buy stocks. But why do people buy stocks? They’ll buy stocks because they think price is going to go up and make them a lot of money. They can sell it at an advantage. That’s what most people think, right? Do I buy stocks for dividends? Some people don’t even know what a dividend is, they just think of stock as something whose price goes up. It doesn’t make sense to think that the price of anything would go up if that’s all there is to it. Why would people pay any price for stocks if there weren’t some way to get money out? The ultimate thing is the dividend; the dividends, even though a lot of people forget the dividends and don’t realize how important they are, they are actually the driving force.

I wanted to just show you a plot that you already saw in your — if you looked on the spreadsheet that I had up. This is the stock market for the United States; it’s the Standard & Poor Composite. In 1957, they reformulated it and they called it the Standard & Poor 500, but I’m using their long theories, back to 1871, so I can’t call it the 500; I’m calling it the Composite. What this is is the price of a portfolio of shares in U.S. companies. It’s kind of like the average price of a share adjusted for splits because you don’t want the — obviously when they do a two-for-one split, the price falls in half and that’s meaningless, so you want to correct for splits. S&P corrects for splits and follows the price of a share. Now unfortunately, the same companies are not around — the companies that we had in 1871, hardly any of them even exist anymore. What they do is they’re pricing a portfolio up here and they keep substituting in new ones. There’s an index committee that keeps bringing in new shares when new companies become important; they try to get the 500 representative of the most companies in the world — in the U.S. You can see that’s what the price has done.

There are also the earnings per share. What are earnings per share? Earnings are something that accountants have generated and they’ve been doing it all the way back to 1871 — it’s a venerable concept; it’s how much money the company made this year, if it’s annual earnings. The price of a share is the price of the ownership of that earnings’ stream, forever. If I buy a share I’m in with everyone else who owns the company and I have a claim on the earnings’ stream, but the earnings’ stream is a year-by-year thing. It just tells you how well they did in that given year. You can see that the stock market has been more volatile than the earnings and the price of a share is many times higher than the earnings per share. So, typically the ratio of price-to-earnings has been about fifteen. That means that people will pay up front for about fifteen years’ earnings.

Earnings and dividends are different; earnings is the money that the company made in a given year. How do they know what they made? That’s a complicated thing that accountants figure out and accountants find it difficult to define the earnings of a company, but they do something and they come up with a number. It may surprise the company directors how much we made or how little we made according to the accountants. The dividend is something much more concrete. This is what they actually send out — this is cash sent out to shareholders. “Earnings” is kind of a theoretical concept that accountants work on and it can go up and down depending on adjustments they make. They might decide that we have some investment over there that we just lost money on and we should take a write off for that. The management might say, well what do you mean we didn’t lose any money this year? But the accountants thought we did. So that’s earnings.

Dividends is very concrete, it’s what they send out. Here is the price-earnings ratio for the U.S. stock market from 1881 to the present — this is also on that spreadsheet that you have on the website. You can see that I’m saying about fifteen — fifteen times earnings is typical, but we’re in a high price-to-earnings scenario now. It goes up and down depending on the outlook for earnings and maybe other factors. The red line is long-term interest rates, but I won’t talk more about that right now. The earnings is a measure of the value of the company and typically they’ve been valued at something like fifteen times earnings. When the price-earnings ratio gets high like it did in 1929 people get antsy. They thought, oh my God, the price earnings ratio is thirty-five. Again, this is price divided by ten-year earnings, not one-year earnings. This is what I do. We had an extraordinarily high price-to-earnings ratio representing a lot of optimism in the ’20s for the stock market and then it corrected and went abruptly downward — that was The Great Depression. We had a similar, even higher price-to-earnings ratio of about forty-six at the peak in 2000 and it corrected way down. The price reflects — really, when you buy a share of a company you own it forever. You will be — you are entitled to receiving the dividends that are paid out of earnings for the rest of your life and you can give it to your children and maybe in two hundred years from now it’ll be worth a lot; probably not, but it might be. It probably won’t even in exist in fifty years but it will be bought by some other company and it will still have value and will still be going up. That’s the price-earnings ratio.

The earnings, you understand, are kind of a theoretical concept but dividend is the money that we send out. How does the company decide on dividends? That’s again up to the board to decide or they can set up a committee on the board that would decide, but ultimately, that’s a major decision to send out dividends. Typically, young companies do not send out dividends. If you set up a company, you don’t want to pay a dividend for a while because you need the money and you’re reinvesting it in the company and people will understand. They don’t expect to get their money out of an investment right away. As a company matures, then they typically feel that it’s time to pay a dividend. The S&P 500 is 500 companies, who are major companies, so these tend to be mature companies and they tend to be in the dividend-paying stage.

The question then is — the payout ratio is dividends over earnings, I say Div/E. I have the payout ratio for the United States; that’s the payout ratio going back to 1871. There are some spikes up like, for example, in — what year — that was 1921 maybe — this year, this is 1932 or 1933 — the companies were paying out 160% of their earnings as dividends. You might say, well what’s going on here? It was The Depression. What was actually happening was, The Depression was killing these companies; they weren’t making any money, but they didn’t want to cut their dividends because they were afraid that if they cut the dividend people would be upset. They’re trying — maybe they did cut it but they didn’t cut it too much, so that means that they were paying out more than they were earning. That’s what typically happens in these spikes; it was a crisis. Now, there’s also a trend downward. They used to pay out typically like 80% of their earnings but it’s been gradually going downward and now it’s down to like 40%. That’s a cultural thing, I would say; it’s that companies now are wanting to keep the money. It may have to do with the fact that people today don’t seem to be as focused on dividends and so that means that companies are more able to reinvest earnings and not pay.

This is the dividend-price ratio back to 1871. Back in the late nineteenth century the dividend price ratio was typically 5%. I think it was clearer in those days. In terms of just general investing culture — and we’re behavioral in our attitude — it was clearer that you bought a stock to get a dividend. Stocks were kind of different in those days. They were more like railroads or steel companies and it was just understood. If someone were recommending you a stock, you’d first say, what is its dividend? And if someone said, it’s 4%, you’d say, well that’s kind of meager, I want a better dividend than that. Now, people don’t seem to be focused on them. In another sense, they’re more willing to entrust the money back to the board of directors to decide on when and whether to pay dividends.

Chapter 5. Stock Repurchases and the Modigliani-Miller Proposition [00:42:38]

Now the other thing is, there are other ways to get money out of a company without paying a dividend and one of them is stock repurchase. There’s also liquidation. Let me mention liquidation or sale of company. I’ll talk about this — the company doesn’t ever have to pay a dividend. All it can do is keep piling in the money and accumulating it and then someone will buy the whole company and then all of the shareholders will be bought out at a termination date. That’s one way that a — but often, when companies are bought out, they don’t give them cash they give them shares in the acquiring company. So, then you would be relying on getting dividends from the acquiring company. I don’t emphasize this cash sale of a company, but it does happen sometimes.

The other thing that a company can do to get money out is share repurchase — a stock repurchase or a share repurchase. It’s perfectly — this sometimes surprises people when they first think about it. You, as an individual, can call up your broker and say, I want to buy Google shares. But Larry Paige at Google can call up a broker — he better get the board’s permission — somebody at Google can call up a broker and make the same statement: we want to buy Google shares. You might say, well how can Google buy Google? “Why not?” is the answer. Why shouldn’t Google buy Google shares? Then you might — well let me ask you this, what would happen if Google decided to buy up all of its shares? Could that happen? I’m the CEO of Google and I call the broker and I say, how many shares are outstanding? Like 100,000,000 or some–no, it wouldn’t be 100,000,000 — we know the price is $500 a share — well, I could figure it out more or less. The answer is, you — let me put it this way. Let me see if this will help you understand.

Suppose Larry Paige calls up and says, I’d like to buy all of the Google shares, and the broker says, alright I’ll get them for you. Then he comes back and says, I managed to get all but one hundred shares and there’s this one guy — this Yale student — who owns one hundred shares of Google stock and I’m having trouble getting him to sell. So, the broker calls you up and says, Google wants to buy all of its shares — I’m being silly here. What do you say to the broker then? So, the broker calls you up and says, you’re the last guy, you have the last one hundred shares in Google and Google wants to buy them and we’ll give you $500 a share. So what do you say? You say no. Actually, I have a better thing, you say, call Larry Paige and tell him he’s fired because I realize I own the company. If I own the last one hundred shares, it’s all mine; I don’t have to take any — I can do whatever I want. The last shareholder — so a company can’t buy all of its shares but it can buy some of its shares and that’s another way to get money out of the company.

It’s a little different if they buy — suppose you own a hundred shares and they declare a 5% cash dividend, then you get $5. But what if the company buys back 5% of its shares? What happens then? Well, the company is still paying out money in the same amount total, but it’s coming out in a different form; it’s coming as a share repurchase. It’s changing the number of shares outstanding, so the value of the company declines by the same amount; it has to, as if they had just paid a dividend. If they’re sending out money, the value of the company has to go down by whatever they sent out. With share repurchase, the number of shares goes down, and if they don’t do share repurchase the number of shares doesn’t go down. So in a sense, it’s all the same to me as a shareholder whether they pay dividends or they repurchase shares.

I don’t know how clear that all was; let me just write this down. This idea has a name. Two authors, both who won the Nobel Prize in finance, Franco — and I know I was his advisee in my PhD, so I learned how to pronounce his name–Modigliani — because in Italian you don’t pronounce the “g,” although I tend to say Modigliani just to be understood — and Merton Miller. Modigliani is one of the authors of your textbook along with Fabozzi. Modigliani and Miller wrote a famous article arguing that — what I just said — I just tried to say it in very intuitive terms. They said, dividend policy is irrelevant. Although, they do put it in a qualifier that it could matter for tax reasons. In fact, you have to put that qualifier on just about anything you say in finance because the tax system is infinitely complex and every country has different taxes, different states have different taxes. There’s nothing you can say boldly in finance if you allow taxes. Well, let’s just disregard taxes. When Modigliani — this sounds like a very strong proposition about dividend irrelevance. What they’re saying is that of course lots of things that a board of directors decides to do are not irrelevant; it’s highly relevant to the future of the company. But real things matter, like if the company decides to build that new plant in Akron. That matters for the company because if the plant works out to be a success, then the company will do well. They’re spending money on concrete, and bricks, and machinery, and they could be doing that wisely or unwisely and that’s beyond finance to evaluate.

What Modigliani and Miller said, if it’s pure dividend policy, then it is totally irrelevant; it means nothing, so companies can do whatever they please — I don’t care. You, as a stockholder — I don’t care what they do. The reason Modigliani and Miller said that is that they were thinking that if the dividend policy is going to be changed without changing any of the activities of the firm, keeping it a purely financial change, then it must be that they’re switching from dividends to stock repurchase or stock repurchase to dividends. You see, you can keep the operations the same whether or not you pay a dividend, if choosing not to pay a dividend means substituting stock repurchase for dividend. So I’m going to build that plant in Akron, whether I pay a dividend or not, because if I need to cut my dividend in order to get the money to build the plant I would also be cutting my stock repurchase. One way or the other it doesn’t — it all comes out to the same thing.

Let me put it in the simplest way. I think the simplest way to understand Modigliani-Miller proposition is the following: imagine that we, as a board, decided to pay a dividend of $5 a share. Let’s talk in the old days about sending checks out, alright? We’re going to send a letter to all our shareholders and say, we have decided to pay a $5 dividend and so you’re about to approve this at the meeting. We approve a letter — the letter’s going to say, we’re making money here’s your dividend check. Then someone says, hey why don’t we just change it? Why don’t we say the same $5 check is included but, in the letter, let’s say something different? Let’s say this is a repurchase of some of your shares at market price, sending the same check, so what’s the difference? Well, I’ll ask you, what difference does it make? Suppose you get a letter from your company saying, congratulations here’s a $5 dividend and here’s a check for $5 if you owned one share. Or the company says, congratulations we’re repurchasing 2% of your shares and here’s a check for $5 to pay you for those shares. And by the way, we’re doing that with all shares. Well, if you think about it, it doesn’t make any difference to me. It doesn’t matter what that letter says — I can crumple it up and throw it in the wastebasket. I don’t — I want the $5 check.

If they’re paying me by sending money and calling it a dividend it’s the same as if they say they’re repurchasing my shares. Because it’s — repurchasing my shares, if they do it for everybody, doesn’t mean anything. I’m getting — we’re all lowering — all of our shares are going down by the same amount. So, that’s the basic insight in Modigliani and Miller, that share repurchase and dividend are really interchangeable; it’s just all a conceptual difference. This kind of took people by surprise. It’s kind of — it should be obvious, I’m making it so simple. I could write some mathematics to try and — but I think it’s so simple and obvious. You just have to keep remembering that all that matters for a company — for you as a — your interest in a company depends on your shares divided by the total number of shares. In a stock repurchase, if they repurchase everybody’s shares — the same proportion — it doesn’t affect that ratio. So, you don’t care what the letter says — whether it says dividend or stock repurchase.

Why would a company want to do one or the other? Well, Modigliani and Miller are leaving the room; they say it doesn’t matter. If you ask them why a dividend payout policy has changed — there’s a famous Miller quote — he calls it a “neutral mutation,” as a reference to evolutionary biology, that sometimes mutations are neither advantageous nor deleterious. The genome starts piling on mutations that mean nothing; that’s how they date the branches of the genome, by looking at the number of neutral mutations. He said all this — this thing that I have up here — well the previous slide, showing the dividend earnings ratio — it’s just cultural; it means nothing because, to some extent, what’s not shown in that diagram was the stock repurchase.

I want then finally to talk about Modigliani-Miller and debt. Now, I didn’t talk too much about debt yet. Before I talk, I just want to say one more thing about Modigliani-Miller and dividend — irrelevance of dividends. There is a possible correction to be made due to taxes. When Modigliani and Miller wrote, there was a differential tax rate between dividends and capital gains. It was — Modigliani and Miller said back then — this was thirty or forty years ago — that companies should really not pay dividends because dividends were then taxed at a higher rate than capital gains. You don’t want to give your shareholders taxes. You should, in your fiduciary duties as a board member, be trying to help them lower their taxes. It doesn’t say that in the state law but that would be inferred as a duty. So, you would avoid paying dividends and, therefore, switch to share repurchase as your method. It took decades for Modigliani-Miller to kind of sink in. As you can see, part of the reason why the dividend-earnings ratio — especially in more recent years, since 1990 — has been declining is that corporations were trying to somewhat ease the tax burden on their shareholders by doing repurchase instead of dividend.

However, that all changed in 2003 with the Jobs and Growth Tax Reconciliation Act of 2003, which cut the rate of taxation of dividends to 15% — the same rate that capital gains are taxed. There is now no preference — well it could be — there are lots of complexities in the tax law but, basically, dividend policy really is irrelevant now. If there’s no tax advantage to one over the other it is completely neutral.

Chapter 6. Corporate Debt and Debt Irrelevance [00:57:13]

The other thing that I want to say about Modigliani and Miller is about corporate debt. I talked about a company as having only shares outstanding, but they also have debt outstanding. So, a company can borrow money. If a company borrows a lot of money it’s called “leveraged.” Leverage is measured by the debt-equity ratio. Now, D here stands for debt; a minute ago I was using Div to stand for dividends. They both start with the letter D but they’re very different concepts. The debt of a company is the amount of money it owes either to banks, or to bond holders, or to note holders, or commercial paper holders; these are fixed incomes. In other words, they are not shares in the company. When a company becomes leveraged, it then becomes riskier. The company becomes riskier because the earnings they have available after paying interest on the debt, or repayment of principle of the debt, is what they have available for dividends. If debt becomes high relative to their revenue stream then the company is in a riskier situation.

There’s another Modigliani-Miller theorem about debt, which is about debt irrelevance as well. That sounds funny, but in a sense, that is — we have to define the sense in which it’s irrelevant. It certainly isn’t irrelevant to the price of a share. The more money a company borrows the more risky the share becomes. It’s just like if you buy a house and you buy - a lot of people are very leveraged now. They might put only 10% down on a house, so you buy a house for $300,000 and you put $30,000 down; that’s an investment of $30,000 but it’s highly risky because you are very leveraged when you only put 10% down. Suppose the home price falls by only 10% — in fact, that’s what’s been happening lately. Your $30,000 down payment is completely wiped out because you were leveraged. You bought the house for $300,000; you sell it for $270,000 that’s exactly what you owe, so you have nothing left. So, leverage brings risk.

Boards of directors have long agonized over how much to borrow and different companies seem to have different cultures. For example, Microsoft has avoided borrowing any money and they don’t believe in debt, so they are not leveraged. But other companies get heavily indebted and then they can go through big problems. It’s a very common item of discussion at board meetings about how much should our company borrow, so they seek advice from financial experts. They call in Modigliani and Miller and ask, how much should we borrow? What do finance theorists say? In the extreme case, where we disregard taxes and we have to disregard some other problems, we get the same answer. Modigliani and Miller said, we don’t care what you do, do whatever you want — it doesn’t matter. This is what I want you to think about on the problem set. Or, maybe speaking about the answer to the questions on the Problem Set #4 will help you to think this through.

The simplest way to see Modigliani-Miller debt irrelevance is the following: a company — if you wanted to buy a company, you could buy only the shares, or equity. Incidentally, did I ever — equity equals shares or stock, so when I talk about debt-equity ratio, I’m talking about the ratio of the value of the company’s debt to the value of all of its stock. If you wanted to buy a company up and own it yourself completely, you could conceive of buying all the shares in the company. There are ten million shares outstanding — I’m going to buy ten million shares. But in a sense, I don’t really own the whole company yet because the company owes money. What if I wanted to buy the whole kit and caboodle — the whole operation? I should be buying all the equity and all the debt as well, right? If the company issued — if I really want to own it and I have no — I really wanted to be the tycoon and this is my baby, nobody else can get in my backyard; I can do whatever I want — you’d have to buy all the equity and all the debt. Otherwise, if you don’t buy all the debt, you still have a problem because those debtors can go after you because they are — they’re not shareholders but they have rights and they could come in and say, we don’t like what you’re doing; we’re going to sue you because we think that you’re doing something contrary to our interest as debtors. If you really want to buy the company, you buy up all its equity — all of its shares — and all of its debt.

The basic insight about Modigliani and Miller debt irrelevance is that, in the absence of taxes or any other special thing, the real value of the company is going to be unaffected by whether they finance by debt or by equity because the real value of a company is determined by the cash flow that they generate by the business they’re doing. So, they are selling widgets or whatever and making money — the value of the company is the present value of that cash flow. If you want to buy the company you have to buy up all the debt and all the equity. From the standpoint of a buyer of the whole company, what do I care how the ownership of the company is divided up between debt and equity? I have to buy them all anyway, so I don’t care whether three-fourths of my money goes to debt or one-fourth of the money goes to debt. I just want to know the bottom line; how much do I have to pay for the whole company?

The debt irrelevance theory says that it matters for the price of a share what a company issues — how much debt it takes on — but it doesn’t matter for the value of the company. There’s almost an arithmetic relationship theory that they put forth. I’m not going to go through their numbers but the value of the company, as a whole, is really determined by something outside of finance.

Again, we have to qualify the debt irrelevance for taxes. So, companies might be concerned with the fact that debt is tax-deductible for corporations on their corporate profits tax but dividends are not. According to Modigliani and Miller, if you add taxes to their debt irrelevance proposition, it means that companies will want to borrow a lot and the real advice they would be giving to Bill Gates is: what’s the matter with you? Why aren’t you borrowing money? It’s tax deductible, whereas dividends are not. That would mean that companies should try to push their debt-equity ratio up as high as possible given that theory. On the other hand, if they do so, they may be courting bankruptcy. If the company gets too leveraged then there’s too high a probability that the company will fail and there are costs to bankruptcy.

The other qualification is bankruptcy costs. A company, according to Modigliani and Miller, has to weigh their tax considerations against their bankruptcy costs and get an optimum debt-equity ratio out of that. It is an insight that Modigliani and Miller are offering the corporations that I think they often don’t see that the real issue in the dividend — both the dividend and the debt policies — are really taxes and nothing else.

Chapter 7. The Lintner Model of Dividends [01:07:58]

The last thing, I just wanted to say — I wanted to mention the theory of dividend payout given by John Lintner; it’s called the Lintner Model of Dividends. I’m saying that, unless tax considerations intervene, dividend policy is really irrelevant for a firm. Maybe Merton Miller is right — these things are “neutral mutations” and changes in dividend policy are meaningless. But how do they actually do it? How do boards and their committees decide how much to pay out in dividends? John Lintner was a professor at the Harvard Business School, who, decades ago, did a survey of people who decide on dividends and asked them, what goes on in your mind and what do you think about when you decide on dividends? He had a long discussion; they said millions of different things — it’s very hard. People who decide on dividends are facing a complicated issue.

One thing that Merton Miller (sic) distilled from it was that people on boards, who decide on dividend payout, are very focused on the price of a share and they’re worried about investor reaction. Boards always want to keep their price of a share up because if it starts to decline, the company could become a takeover target; it’s viewed as a failure etc., etc. They talked a lot to him about investor psychology. In a sense, I’m terminating this lecture with another triumph for behavioral economics. When we think about the theory of dividend or debt we end up with irrelevance — it doesn’t mean anything — but the companies’ boards talk about it incessantly and it seems to matter a lot to them. If you ask them why it matters, they say, well it’s pretty obvious — it’s all their investor psychology that we have to deal with. They say things like this: if we pay a dividend, then they’re going to start expecting that. And if we don’t pay a dividend once, then they’re going to say, what’s wrong? As long as we never start paying a dividend, then we’re just a young company and nobody asks any questions. Then we start paying a dividend and then if we ever have to cut it, we’re in big trouble. The newspaper reporters will start calling, why did you cut the dividend? You said, you didn’t call us up when we weren’t paying any dividend and now we’re still paying more than we used to, why all this alarm?

They said — one of the lessons they were told is, never cut a dividend unless you do it as a — you could do a one time only dividend. Say, we’re just doing this once and don’t expect it again. But if you start paying regular dividends, then you better keep doing them or people are going to conclude that something is really wrong. They told him that if earnings go up — we try to keep a target payout ratio — but if earnings suddenly shoot up, we’re not going to increase our dividends right away because that would set too high an expectation and we don’t want to have to cut it. So if earnings go up a lot, we’ll raise our dividends, but only part of the way up. The model that–I better get it right — the Lintner Model says that there’s a target payout ratio — that’s the Greek letter tau (τ) and that’s the target payout ratio. That ratio may have been higher in the nineteenth century; it’s gradually trending down, but it’s a slow-moving thing. So they want to payout something like 40% of their earnings as dividends and plow the rest back into investing inside the company. Then there’s another parameter, rho (ρ), which is the adjustment — rho is between zero and one. It’s how fast they adjust to the target.

So the Lintner Model then says, the change in dividends, Div_t - Div_T-1 = ρ (E_t - Div _{T – 1}). That means that if your rho is from a positive number like half — so if earnings is above dividends you increase your dividends, but only by half as much as would bring it up to the target, if rho is a half. That means there’s a gradual adjustment of dividends to earnings. For example, if this is tau and this is earnings — if your earnings were, say, flat and suddenly increased like that, they wouldn’t believe this increase at first, so the board would decide to adjust only, say, half way up. Now I’m plotting dividends. The dividends were down here at half the earnings and then you would gradually adjust them up to half the earnings again. That’s because they don’t want to ever be caught cutting their dividends. Also, if the earnings drop, they don’t want to suddenly do a crash cut in their dividends either, so they’re always sluggishly adjusting toward the target payout rate. Lintner showed that this simple model — the Lintner Model — explains the behavior of companies pretty well. Next session is Friday with Stephen Schwarzman and I’ll see you then.

[end of transcript]

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