WEBVTT 00:02.200 --> 00:05.870 Professor Robert Shiller: I believe that we 00:05.867 --> 00:09.457 still have on, for Friday, Stephen Schwarzman. 00:09.460 --> 00:11.290 He said he would do it. 00:11.290 --> 00:16.280 I always worry about people who have such important businesses 00:16.282 --> 00:21.032 because some big deal may become in crisis or something; 00:21.030 --> 00:24.630 people like that have trouble sometimes adhering to a 00:24.628 --> 00:27.828 schedule. As far as I know we're getting 00:27.833 --> 00:32.723 him, so I hope that you will all be able to come this Friday, 00:32.720 --> 00:34.920 here, at the usual time. 00:34.920 --> 00:40.190 If there's any problem with his appearing I will email you. 00:40.190 --> 00:43.370 As you know, Stephen Schwarzman is a 00:43.365 --> 00:48.805 graduate of Yale College and he's one of the great stories of 00:48.808 --> 00:53.198 our century. He created just about the 00:53.201 --> 01:00.731 biggest private equity firm from scratch in 1985 and I guess they 01:00.731 --> 01:06.851 just went public and they have a huge market cap. 01:06.849 --> 01:10.459 They're comparable to one of the biggest old line investment 01:10.464 --> 01:11.694 banks in New York. 01:11.689 --> 01:16.029 He just--he and Peter Peterson--just created it so I 01:16.027 --> 01:20.107 think it will be very interesting to hear him. 01:20.110 --> 01:25.290 Again, you'll have a chance to question him about what he's 01:25.294 --> 01:28.234 done. I put on the reading list 01:28.228 --> 01:33.028 The New Yorker article that's out right now. 01:33.030 --> 01:36.730 Well actually, I guess it came out a couple of 01:36.734 --> 01:40.114 weeks ago, but it's up on our syllabus. 01:40.110 --> 01:44.040 I think I might want to take it down before he comes. 01:44.040 --> 01:48.980 I'm going to turn--I'm going to reflect on this because he may 01:48.984 --> 01:51.744 not be pleased with the article. 01:51.739 --> 01:57.529 It's a very hard-hitting critical article. 01:57.530 --> 02:01.700 He had to be a tough businessman to arrive where he 02:01.702 --> 02:04.612 is. The New Yorker article 02:04.610 --> 02:09.510 talks about the price of his condo--or co-op--in New York, 02:09.506 --> 02:13.796 which set some record, and so they tell things like 02:13.801 --> 02:17.051 that. I was just yesterday in London 02:17.048 --> 02:21.028 and people like to gossip about things like that. 02:21.030 --> 02:24.570 The limo driver was driving me to the airport and was pointing 02:24.565 --> 02:26.125 out the scenes in London. 02:26.130 --> 02:27.470 He said, you know that building? 02:27.470 --> 02:31.950 Some Arab Sheikh just paid one hundred million pounds for that 02:31.950 --> 02:36.060 apartment--that penthouse apartment--in that building and 02:36.064 --> 02:40.554 the same Sheikh is ordering a Airbus for his--one of these big 02:40.545 --> 02:44.585 Airbus airplanes--for his personal plane and he's having 02:44.585 --> 02:47.005 it plated with gold leaf. 02:47.010 --> 02:48.630 Did you hear this story? 02:48.630 --> 02:50.180 Does anyone--is this true? 02:50.180 --> 02:52.440 This limo driver told me this yesterday; 02:52.440 --> 02:56.690 he said it's going to cost him five hundred million pounds or 02:56.691 --> 02:59.031 something like that to do this. 02:59.030 --> 03:01.740 These are gossip. 03:01.740 --> 03:06.930 The real substance is what the man does--or woman does--for the 03:06.930 --> 03:09.550 world. So, I gleaned here a list of 03:09.554 --> 03:13.044 some of the charities that--Stephen Schwarzman is a 03:13.044 --> 03:14.724 major philanthropist. 03:14.719 --> 03:20.109 He set up something called The Blackstone Foundation from the 03:20.107 --> 03:25.407 Blackstone Group and he's a major donor or collaborator with 03:25.405 --> 03:29.125 the Frick Collection, The Whitney Museum, 03:29.125 --> 03:31.295 Phoenix House, The Red Cross, 03:31.301 --> 03:34.021 The Inner City Scholarship Fund, 03:34.020 --> 03:40.350 New York City Outward Bound, and the Asia Society. 03:40.349 --> 03:42.719 I think that's the real thing we should talk about, 03:42.721 --> 03:44.241 not the size of his penthouse. 03:44.240 --> 03:49.240 So, I might try to find a more even-handed account and put that 03:49.237 --> 03:50.847 up on the website. 03:50.849 --> 03:55.309 Incidentally, there's sort of a resemblance 03:55.314 --> 04:00.634 between him and David Swensen in the–well, 04:00.629 --> 04:02.739 first of all, they're both phenomenally 04:02.737 --> 04:05.617 successful, but they both are emphasizing alternative 04:05.622 --> 04:09.622 investments. They're not straight-laced 04:09.623 --> 04:12.813 old-fashioned; they're willing to take 04:12.806 --> 04:17.166 experiments. I think he should be very 04:17.168 --> 04:22.168 interesting; that's Friday at 9. 04:22.170 --> 04:28.360 I want to talk about the stock market today and I thought I 04:28.362 --> 04:34.552 would keep it more or less basic because I think--I want to 04:34.553 --> 04:37.653 emphasize basic concepts. 04:37.649 --> 04:41.429 A lot I'm going to talk about is Modigliani-Miller but I'm not 04:41.428 --> 04:45.298 going to get too deep into it, maybe in your review sections 04:45.302 --> 04:47.132 you can get more technical. 04:47.129 --> 04:50.939 I'm going to just talk about it in the very intuitive, 04:50.941 --> 04:58.291 direct terms. What are stocks? 04:58.290 --> 05:01.380 I think the idea of a stock must have been invented 05:01.383 --> 05:03.923 independently at many times in history. 05:03.920 --> 05:09.420 The word "shares" is the fundamental word. 05:09.420 --> 05:14.320 Suppose you are starting a business with somebody--it could 05:14.322 --> 05:17.532 be at any time in history--Babylonia or 05:17.533 --> 05:20.833 something--this must have happened. 05:20.829 --> 05:25.669 A group of people starts a business and they say, 05:25.672 --> 05:28.802 let's divide up the proceeds. 05:28.800 --> 05:30.240 That's very direct, isn't it? 05:30.240 --> 05:33.780 If we're all working together we divide up the proceeds. 05:33.779 --> 05:36.639 That means we're allocating shares. 05:36.639 --> 05:40.439 Now, I don't know how far back it goes but it must be that in 05:40.435 --> 05:42.835 ancient times some people would say, 05:42.839 --> 05:45.549 all right you're going to be doing more work or you're 05:45.547 --> 05:47.537 contributing more to this enterprise, 05:47.540 --> 05:49.880 we'll give you a bigger share of the profits. 05:49.879 --> 05:54.419 That's so basic, it must have happened a million 05:54.417 --> 05:59.627 times and that's the basic idea of the stock market. 05:59.629 --> 06:05.549 All it is is that we've got it much more high-flown and much 06:05.547 --> 06:11.467 more legalized than--the basic idea is that you have to have 06:11.465 --> 06:16.875 shares in something--a business--and the idea goes back 06:16.881 --> 06:19.891 clearly to ancient Rome. 06:19.889 --> 06:24.969 Let's consider a business as sort of a person who is owned, 06:24.969 --> 06:28.909 like a slave, who is owned by other people. 06:28.910 --> 06:32.750 In law, the word "person" doesn't mean what you think it 06:32.751 --> 06:35.101 means. There's--in law, 06:35.098 --> 06:38.898 a "natural person" is you and me; 06:38.899 --> 06:43.099 people, real flesh and blood individuals are called natural 06:43.096 --> 06:45.886 persons. But when we say "person," it 06:45.885 --> 06:50.085 also--that's more general--it also includes corporation. 06:50.089 --> 06:53.099 The word "corporation" comes from the Latin, 06:53.095 --> 06:56.305 corpus, meaning body, so it's an embodiment. 06:56.310 --> 07:00.650 We create an entity that, in the eyes of the law, 07:00.649 --> 07:02.819 is like an individual. 07:02.819 --> 07:06.499 It may be owned by other individuals but it has its own 07:06.499 --> 07:10.109 rights and responsibilities as if it were a person. 07:10.110 --> 07:13.460 In ancient Rome, corporations were called 07:13.463 --> 07:18.833 publicani--that's Latin; the publicani were 07:18.825 --> 07:21.935 companies like we have today. 07:21.939 --> 07:26.799 According to the research of Ulrike Malmendier at Stanford, 07:26.795 --> 07:31.475 she thinks that the stock market in ancient Rome was done 07:31.484 --> 07:36.014 on the street--on the Roman Forum--and she can tell you 07:36.005 --> 07:38.155 where. When you go to Rome, 07:38.162 --> 07:41.392 you can walk and see what's left of their stock market. 07:41.389 --> 07:46.919 It never flourished really until relatively modern times. 07:46.920 --> 07:51.070 The idea, of course, is that we have a legal 07:51.067 --> 07:56.467 entity--a corporation--that issues shares that are either 07:56.467 --> 08:02.057 given to people or purchased by people and the idea is that 08:02.061 --> 08:05.631 shares represent contributions. 08:05.629 --> 08:09.409 You give shares to someone who is contributing to the 08:09.413 --> 08:12.533 enterprise. You can--when you set up a 08:12.530 --> 08:17.370 corporation there are different kinds of relationships that 08:17.371 --> 08:20.711 people might have with a corporation. 08:20.709 --> 08:24.129 One of them is as a shareholder and the shareholder gets a 08:24.129 --> 08:27.009 share--is entitled to a share--of the profits. 08:27.009 --> 08:31.219 There are also employees who get wages and that's very 08:31.217 --> 08:34.837 different. They have a labor contract that 08:34.840 --> 08:37.770 specifies how much they will get. 08:37.769 --> 08:42.939 Then you have debtors and other people with other relationships. 08:42.940 --> 08:45.610 The fundamental one is the shareholder because the 08:45.605 --> 08:47.505 shareholder owns the corporation. 08:47.510 --> 08:55.820 08:55.820 --> 09:01.750 As it's evolved in modern times, the corporation has a 09:01.751 --> 09:03.991 charter or bylaws. 09:03.990 --> 09:07.230 When you create a corporation you write up a contract, 09:07.228 --> 09:10.098 which specifies the rules of the corporation; 09:10.100 --> 09:12.230 it's like a constitution for the corporation. 09:12.230 --> 09:16.580 Also, the law of the state in which the corporation is 09:16.583 --> 09:21.843 chartered also puts restrictions on what can be in the bylaws. 09:21.840 --> 09:26.440 Notably, it's typically required that it's one share, 09:26.443 --> 09:31.583 one vote and that there's a--it would be also required that 09:31.578 --> 09:36.268 there be an annual meeting--at least once a year, 09:36.269 --> 09:40.839 a shareholder meeting--and then the shareholders can vote on 09:40.836 --> 09:43.776 relevant issues. One of the most important 09:43.779 --> 09:46.629 issues then is to elect a board of directors. 09:46.629 --> 09:50.909 The state law probably requires that a corporation have a board 09:50.905 --> 09:53.505 of directors, but it's also something that 09:53.510 --> 09:56.870 can be defined at the time that you create the corporation in 09:56.874 --> 10:00.494 the bylaws. It's not something you can do 10:00.488 --> 10:02.828 just whatever you want. 10:02.830 --> 10:09.610 State law has requirements for the board of directors and--I'm 10:09.605 --> 10:14.155 just going to talk in very basic terms. 10:14.159 --> 10:17.769 The usual structure is one shareholder, one vote. 10:17.769 --> 10:22.519 At the annual meeting, the shareholders can come and 10:22.521 --> 10:28.391 elect a board and the board then is in charge of the company. 10:28.389 --> 10:33.079 The board hires the president or chief executive officer and 10:33.075 --> 10:37.045 other top officers of the company and they serve as 10:37.045 --> 10:39.185 employees of the board. 10:39.190 --> 10:43.750 The theory is that the shareholders are in control 10:43.746 --> 10:49.416 because they elect the board and the board hires the president 10:49.418 --> 10:51.648 and it's democratic. 10:51.650 --> 10:54.890 I'm going to come back to it; it doesn't always work out as 10:54.892 --> 10:56.522 perfectly as you want. 10:56.519 --> 10:59.739 Now there's basically–there are 10:59.744 --> 11:05.034 important distinctions between two kinds of corporations. 11:05.029 --> 11:08.249 There's for-profit and non-profit. 11:08.250 --> 11:11.190 I've been describing a for-profit corporation, 11:11.187 --> 11:13.077 which is the usual variety. 11:13.080 --> 11:18.360 Non-profit corporations will also have a board of directors 11:18.363 --> 11:22.193 but they will not have any shareholders. 11:22.190 --> 11:24.500 There's a fundamental difference in the charter and 11:24.501 --> 11:26.351 the way the government reacts to them. 11:26.350 --> 11:32.440 The non-profit organization or corporation is set up to advance 11:32.437 --> 11:36.657 some cause and it is not owned by anyone. 11:36.659 --> 11:39.279 The share price, you could say, 11:39.284 --> 11:41.214 is identically zero. 11:41.210 --> 11:44.750 Actually, you can't say what the share price is because there 11:44.752 --> 11:47.412 are zero shares and they have a zero price, 11:47.409 --> 11:52.509 so the value of the price per share is zero over zero and you 11:52.509 --> 11:56.189 can't define it. Yale University is a non-profit 11:56.188 --> 11:58.998 corporation; the price of a share in Yale 11:58.997 --> 12:02.127 University is undefined--it's zero over zero. 12:02.129 --> 12:07.279 It has a board that runs it, but the board is not liable to 12:07.282 --> 12:08.972 shareholder vote. 12:08.970 --> 12:12.660 Well actually, we have some voting among 12:12.660 --> 12:16.450 alumni I guess, but it's not a for-profit 12:16.445 --> 12:20.345 corporation. I'm going to be talking about 12:20.350 --> 12:24.210 for-profit. Now, the critical thing to 12:24.210 --> 12:30.500 understand about a corporation is that in order to value a 12:30.504 --> 12:36.364 share in a corporation you absolutely have to know the 12:36.355 --> 12:40.105 number of shares outstanding. 12:40.110 --> 12:45.340 If I own one thousand shares in a company, what does that mean? 12:45.340 --> 12:49.650 It doesn't mean anything until you know how many shares are 12:49.647 --> 12:54.097 outstanding because if I own one thousand shares and then you 12:54.103 --> 12:58.633 look it up and find out how many shares are outstanding--there 12:58.633 --> 13:02.723 are one thousand--you say, hey I own the whole company. 13:02.720 --> 13:05.290 It's mine if I own one thousand shares and there are one 13:05.286 --> 13:06.356 thousand outstanding. 13:06.360 --> 13:09.850 What if you own one thousand shares and there are ten million 13:09.846 --> 13:13.826 outstanding? Well, then that means that you 13:13.825 --> 13:17.935 own one ten-thousandth of the company. 13:17.940 --> 13:19.090 Did I divide right? 13:19.090 --> 13:24.450 That's a very important lesson to keep in mind. 13:24.450 --> 13:27.980 People don't usually know how many shares are outstanding in 13:27.977 --> 13:30.007 the company that they invest in. 13:30.009 --> 13:33.139 That's because, in a sense, they're trusting to 13:33.141 --> 13:35.301 analysts. Ultimately, analysts are 13:35.299 --> 13:37.179 supposed to keep track of this. 13:37.179 --> 13:39.939 When they look at the price of a company, how do we know 13:39.944 --> 13:42.814 whether the price at which you're buying is reasonable? 13:42.809 --> 13:45.999 They must be looking at some measure of the value of the 13:46.002 --> 13:49.312 company and dividing by the number of shares and then that 13:49.311 --> 13:52.331 gives them some idea of what the share is worth. 13:52.330 --> 13:56.590 But it's absolutely essential--so the shares only 13:56.593 --> 14:02.193 mean something as a relation to their total number of shares. 14:02.190 --> 14:05.190 Companies routinely do what are called "splits." 14:05.190 --> 14:11.090 They may do a two-for-one split; that means, if you held one 14:11.093 --> 14:16.383 thousand shares you get a letter saying, congratulations you now 14:16.376 --> 14:18.636 own two thousand shares. 14:18.639 --> 14:22.989 Don't be too jubilant because when they do a split they do it 14:22.986 --> 14:25.156 to every single shareholder. 14:25.159 --> 14:29.849 So, you now have two thousand shares, but now there are twenty 14:29.849 --> 14:34.149 million shares outstanding in the company so the ratio is 14:34.153 --> 14:35.863 unchanged. You might ask, 14:35.863 --> 14:37.133 well why do they do splits? 14:37.129 --> 14:40.689 Well, it's just to keep the numbers--there's actually not a 14:40.687 --> 14:42.647 very good reason to do splits. 14:42.649 --> 14:46.279 There's no reason not to do splits either because it's just 14:46.284 --> 14:48.544 changing the units of measurement. 14:48.539 --> 14:51.429 But typically, in the United States, 14:51.425 --> 14:55.955 they do splits to keep the price of a share somewhere in 14:55.959 --> 15:00.129 the $20 to $40 range; there's interesting literature 15:00.131 --> 15:01.611 on why they do that. 15:01.610 --> 15:05.440 Maybe it's a tradition, maybe it's to keep the value 15:05.436 --> 15:10.086 kind of in a familiar range or a small--they don't want them to 15:10.087 --> 15:14.587 get too expensive because people can't--small investors can't 15:14.589 --> 15:16.539 afford them anymore. 15:16.539 --> 15:19.519 Who knows, but the point is it's different in different 15:19.518 --> 15:23.398 countries. So the total number of shares 15:23.399 --> 15:29.839 is almost--the tendency to do splits is a cultural thing; 15:29.840 --> 15:31.790 it's of no real significance. 15:31.789 --> 15:34.599 Warren Buffett doesn't do splits with his Berkshire 15:34.597 --> 15:37.847 Hathaway and there are other companies that--I guess Google 15:37.854 --> 15:40.104 doesn't do splits, isn't that right? 15:40.100 --> 15:42.200 Is that right or are you saying no? 15:42.200 --> 15:45.950 Actually, I don't remember, but they haven't done one yet. 15:45.950 --> 15:49.830 What is the price per share, do you know? 15:49.830 --> 15:58.370 This is getting a little high--$550 a share is kind of 15:58.371 --> 16:06.911 high because most people will buy--this is part of our 16:06.913 --> 16:10.633 tradition. Most people will buy shares in 16:10.631 --> 16:13.311 what's called "round blocks," that's a hundred shares. 16:13.309 --> 16:20.809 So, if it's $550, that makes $55,000 for a one 16:20.809 --> 16:25.179 round lot. I can't multiply while I'm 16:25.183 --> 16:26.373 standing up. 16:26.370 --> 16:33.430 16:33.429 --> 16:35.529 Most companies do splits because that might close 16:35.532 --> 16:37.772 the--you might have been thinking about investing in 16:37.766 --> 16:39.996 Google but you could still--you could just say, 16:40.000 --> 16:42.980 I want to buy ten shares or five shares and the broker will 16:42.984 --> 16:45.254 do it for you, but they might charge a higher 16:45.248 --> 16:52.068 commission. That's the lesson. 16:52.070 --> 16:57.110 There's a term--I should write some of my terms down--a very 16:57.114 --> 17:01.394 important term in finance and that's "dilution." 17:01.389 --> 17:06.889 If the company increases the number of shares through a split 17:06.887 --> 17:12.657 that is not dilution because it doesn't really mean anything. 17:12.660 --> 17:15.830 When you do a split, you're changing the number of 17:15.827 --> 17:19.187 shares for everybody, so it can have no effect on the 17:19.188 --> 17:22.308 ratio for anybody; it's just purely appearance. 17:22.309 --> 17:26.379 Dilution occurs when the company changes the number of 17:26.383 --> 17:30.613 shares asymmetrically--not changing it for everybody. 17:30.609 --> 17:36.229 The typical example of dilution is: the board of directors has 17:36.231 --> 17:42.131 hired a CEO for the company and they want to motivate the CEO. 17:42.130 --> 17:48.030 They can pay the CEO a salary or they can give shares to the 17:48.029 --> 17:53.329 CEO--that's quite standard because they feel that that 17:53.329 --> 17:56.529 makes the CEO a shareholder. 17:56.529 --> 18:00.109 It's like another form of compensation and that 18:00.110 --> 18:04.080 compensation might have different attractiveness, 18:04.079 --> 18:08.259 so they give the person a package--both a salary and some 18:08.258 --> 18:11.068 shares. You see, if they give the--if 18:11.071 --> 18:15.281 they merely give shares to the CEO without increasing your 18:15.281 --> 18:17.731 shares, then you are being diluted 18:17.734 --> 18:21.694 because it's raising the total and it's reducing the ratio. 18:21.690 --> 18:26.510 18:26.509 --> 18:30.549 Now, if a company sells shares, it issues new shares--it can do 18:30.551 --> 18:31.791 that at any time. 18:31.789 --> 18:36.279 When you start a company you might have had--maybe when Peter 18:36.275 --> 18:40.685 Peterson and Stephen Schwarzman founded The Blackstone Group 18:40.685 --> 18:45.015 they gave each of them five hundred shares--I'm just making 18:45.020 --> 18:49.660 that up--but obviously there's going to be more shareholders as 18:49.655 --> 18:53.285 time comes in. One thing that people can do to 18:53.287 --> 18:54.887 get in is to buy shares. 18:54.890 --> 19:01.350 If the company issues new shares by selling them to the 19:01.352 --> 19:05.902 public, it's not obviously dilution. 19:05.900 --> 19:10.230 Of course it's lowering your share of the company, 19:10.232 --> 19:15.712 but offsetting this is that the company is taking in money from 19:15.714 --> 19:21.554 the person who bought the shares and so it doesn't dilute you. 19:21.549 --> 19:25.599 Well, you could say it dilutes it but it doesn't lower the 19:25.599 --> 19:28.369 price of your investment, in general. 19:28.369 --> 19:30.969 It could, depending on a lot of factors. 19:30.970 --> 19:37.730 Dilution occurs--the term specifically refers to changes 19:37.732 --> 19:43.142 in a number of shares that affect, adversely, 19:43.143 --> 19:46.343 existing shareholders. 19:46.339 --> 19:52.699 Another common term is a "stock dividend." 19:52.700 --> 19:54.530 Well first of all, I should talk about dividends. 19:54.530 --> 19:59.090 19:59.089 --> 20:04.059 The stock market--I was going to talk about stock dividends, 20:04.061 --> 20:07.601 but I better talk about dividends first. 20:07.599 --> 20:12.759 In for-profit companies, people are investing in the 20:12.756 --> 20:14.876 company for profit. 20:14.880 --> 20:18.370 How do they get the profit? 20:18.369 --> 20:23.299 Well, the company--the board of directors--decides if and when 20:23.301 --> 20:27.751 to pay dividends to the shareholders and then the law of 20:27.747 --> 20:32.757 the state would say that they must treat them all equally. 20:32.759 --> 20:35.639 They made some money and now they want to take it out and 20:35.635 --> 20:37.925 spend it. They have to do it equally to 20:37.933 --> 20:41.413 all shareholders; that's called paying a dividend. 20:41.410 --> 20:45.610 They can do it on rare occasions, or they can do it 20:45.613 --> 20:50.493 whenever they feel like it, or they can do it regularly; 20:50.490 --> 20:52.260 it's often done quarterly. 20:52.259 --> 20:55.799 When I set up a company--Case Shiller Weiss, 20:55.802 --> 21:00.502 Inc.--typical of young start up companies, we didn't pay a 21:00.498 --> 21:04.058 dividend. We gave shares to almost all of 21:04.063 --> 21:08.893 our employees as part of their compensation and we hoped that 21:08.888 --> 21:13.628 would motivate them and make them feel a part of the company 21:13.633 --> 21:16.773 but we never paid them a dividend. 21:16.769 --> 21:19.739 I remember one time I was talking to our CEO and he said, 21:19.738 --> 21:22.968 you know maybe we should pay at least one dividend because our 21:22.971 --> 21:25.941 employees are forgetting that they own these shares. 21:25.940 --> 21:31.370 So, we paid one dividend and I don't know how much excitement 21:31.373 --> 21:34.003 it generated, but that's the-- 21:34.000 --> 21:39.620 Student: Does this mean that share price will drop by $2 21:39.615 --> 21:41.965 after a $2 dividend? 21:41.970 --> 21:45.050 Immediately after the payout dividend, the share--the price 21:45.053 --> 21:47.023 of the share should go down, right? 21:47.019 --> 21:49.309 Professor Robert Shiller: Yes, 21:49.314 --> 21:52.954 he's asking after a firm pays a dividend that should lower 21:52.948 --> 21:56.648 the--you were asking whether it should lower the price of a 21:56.645 --> 21:59.055 share. Yes, you are absolutely right. 21:59.059 --> 22:04.179 If the company pays out money, the value of the company should 22:04.181 --> 22:08.381 have just gone down by the amount they paid out, 22:08.380 --> 22:11.120 but the number of shares hasn't changed. 22:11.119 --> 22:15.129 That means that the price of each share should decline by the 22:15.132 --> 22:18.812 amount they paid out divided by the number of shares. 22:18.809 --> 22:22.959 There's a term for that--they call it going ex-dividend. 22:22.960 --> 22:29.380 So the company--it used to be you could look on--you can still 22:29.381 --> 22:32.491 see this. Some of these are still listed 22:32.487 --> 22:34.887 on The New York Stock Exchange page; 22:34.890 --> 22:37.890 on the day that a stock goes ex-dividend, they'll have a 22:37.891 --> 22:39.311 little "x" by its price. 22:39.309 --> 22:43.249 The reason they put that there is so that people don't get 22:43.248 --> 22:46.018 alarmed. A lot of people watch the price 22:46.018 --> 22:49.638 of their share everyday--some people get neurotic about 22:49.639 --> 22:53.729 it--and then suddenly it drops by $2 a share and they say, 22:53.730 --> 22:55.210 oh my God I'm worried. 22:55.210 --> 22:57.550 They call up their broker and say, what's wrong? 22:57.549 --> 23:01.269 Then the broker has to explain, no didn't you see the "x" 23:01.268 --> 23:03.118 there? It just went ex-dividend, 23:03.119 --> 23:04.649 so it doesn't mean anything. 23:04.650 --> 23:07.410 The "ex-dividend date" is not the date that you actually 23:07.413 --> 23:11.463 received the dividend, but it's called the ex-dividend 23:11.455 --> 23:16.935 date, which the company decides on that date anyone who was a 23:16.943 --> 23:22.983 stockholder of record gets the dividend and the guy after that, 23:22.980 --> 23:25.440 you don't get that dividend. 23:25.440 --> 23:30.040 That's an important--this really does happen, 23:30.039 --> 23:35.579 stocks really do drop in price on ex-dividend date. 23:35.579 --> 23:38.619 Now incidentally, that's an interesting question 23:38.619 --> 23:41.399 that you bring up, because--should I pay any 23:41.400 --> 23:44.440 attention to dividend dates as an investor? 23:44.440 --> 23:49.970 The answer is generally not because if you buy the stock 23:49.972 --> 23:55.052 before it goes ex-dividend, you get--you have to pay a 23:55.048 --> 23:58.368 higher price, but you get the dividend. 23:58.369 --> 24:01.999 If you wait until the next day, you pay a lower price but you 24:01.998 --> 24:03.508 don't get the dividend. 24:03.509 --> 24:07.689 Unless there are some tax effects, which might matter--and 24:07.685 --> 24:11.415 taxes always complicate things--but disregarding tax 24:11.421 --> 24:17.091 effects, it doesn't matter which you do. 24:17.089 --> 24:20.919 In fact, there's a rule, FINRA, which licenses 24:20.917 --> 24:23.637 stockbrokers, tells their people, 24:23.638 --> 24:28.208 you must not sell dividends; they're referring to a bad 24:28.212 --> 24:32.632 practice that some unscrupulous stockbrokers occasionally do. 24:32.630 --> 24:35.290 They'll tell someone, hurry up and buy this stock 24:35.289 --> 24:37.449 because it's going to go ex-dividend. 24:37.450 --> 24:42.470 If you buy it today--if you wait, you won't get the 24:42.474 --> 24:44.884 dividend. That's misleading because it 24:44.880 --> 24:46.930 really doesn't matter when you buy the stock, 24:46.925 --> 24:48.685 so you're not supposed to, as a broker, 24:48.690 --> 24:51.660 sell dividends. That doesn't mean dividends 24:51.661 --> 24:55.931 don't matter. Ultimately, they're a reason 24:55.925 --> 24:58.325 why you own a stock. 24:58.329 --> 25:03.809 This gets back--People are accustomed to getting dividend 25:03.813 --> 25:05.873 checks in the mail. 25:05.869 --> 25:09.349 If you own stock--we don't get them in the mail anymore because 25:09.349 --> 25:12.439 you own it through some brokerage account and you get it 25:12.435 --> 25:15.055 on a website. You used to get checks in the 25:15.063 --> 25:17.023 mail; now you go on a website and 25:17.020 --> 25:20.660 you'll see that your dividends are credited to your account, 25:20.660 --> 25:24.620 but money is growing in your account as companies pay out 25:24.621 --> 25:27.811 dividends. I was going to talk about a 25:27.808 --> 25:31.358 stock dividend and I started to do that. 25:31.359 --> 25:36.389 Sometimes companies will announce that they are paying 25:36.385 --> 25:40.745 not a cash dividend, but they're paying a stock 25:40.747 --> 25:42.957 dividend. They'll say, 25:42.961 --> 25:48.031 we are pleased to announce that we are paying a dividend in new 25:48.033 --> 25:52.373 shares issued today by the company equal to 5% of your 25:52.369 --> 25:57.359 existing shares--so it's a 5% dividend--congratulations. 25:57.360 --> 26:00.410 Is that a good thing? 26:00.410 --> 26:03.380 How excited should you be to get the letter saying your 26:03.380 --> 26:05.580 company has paid you a stock dividend? 26:05.580 --> 26:07.480 Any ideas on that? 26:07.480 --> 26:12.990 Well, you should be absolutely unexcited because it doesn't 26:12.990 --> 26:16.630 mean anything; if they were giving you extra 26:16.632 --> 26:20.802 shares and just you alone, that would be great--that would 26:20.804 --> 26:23.864 be good. The whole essence of a stock 26:23.857 --> 26:28.747 dividend is that they're paying it to every shareholder in the 26:28.754 --> 26:31.904 same proportion, so every one hundred shares 26:31.895 --> 26:34.105 becomes one hundred and five shares; 26:34.109 --> 26:37.499 so you know that that has no meaning to me. 26:37.500 --> 26:41.830 All that matters is the ratio: how many shares I own divided 26:41.830 --> 26:44.620 by the number of shares outstanding. 26:44.619 --> 26:48.059 If they both go up by the same proportion, then numerator and 26:48.061 --> 26:51.561 denominator go up by the same amount, so there's no change. 26:51.559 --> 26:55.009 Then you might ask, why in the world do companies 26:55.009 --> 26:58.529 issue stock dividends anyway, what's the point? 26:58.529 --> 27:02.159 Are they trying to confuse or fool somebody? 27:02.160 --> 27:05.100 Well, there are different views on that. 27:05.099 --> 27:07.599 One of them is yes, they are trying to confuse and 27:07.602 --> 27:10.232 fool somebody. If they don't have money to pay 27:10.234 --> 27:13.164 the dividend they can always do a stock dividend. 27:13.160 --> 27:14.900 On the other hand, some people say, 27:14.899 --> 27:16.279 well that would backfire. 27:16.279 --> 27:19.359 If they're going to pay stock dividends and try to fool us, 27:19.361 --> 27:20.691 what's going to happen? 27:20.690 --> 27:22.930 The price of a share is going to fall on that day. 27:22.930 --> 27:25.800 When you pay out stock dividends you would think that 27:25.796 --> 27:29.046 now there are more shares, everyone divides by the larger 27:29.054 --> 27:31.634 number of shares, and the value of the company 27:31.626 --> 27:33.636 goes down; it's not going to work to pay a 27:33.636 --> 27:36.036 stock dividend. So, the more enlightened view 27:36.035 --> 27:39.395 is, corporations only pay a stock dividend when they have 27:39.404 --> 27:41.214 some good news to announce. 27:41.210 --> 27:44.090 Typically, they'll write a letter saying, 27:44.087 --> 27:46.747 congratulations we have great news! 27:46.750 --> 27:50.410 We have some new breakthrough and in celebration of this we're 27:50.410 --> 27:53.050 going to pay everyone a 5% stock dividend. 27:53.049 --> 27:57.449 Now, they are hoping that the price doesn't fall because 27:57.450 --> 28:00.490 they're announcing it with news and, 28:00.490 --> 28:02.870 in a sense, issuing the stock dividend is just a way to make 28:02.866 --> 28:03.426 it dramatic. 28:03.430 --> 28:11.010 28:11.009 --> 28:12.849 Now incidentally, in a for-profit 28:12.853 --> 28:15.333 corporation--this is how to understand this, 28:15.331 --> 28:18.041 this is a concept that is enshrined in law. 28:18.039 --> 28:22.769 In a for-profit corporation, the purpose of the entity is 28:22.768 --> 28:26.228 defined as profit for the shareholders. 28:26.230 --> 28:30.500 Now, in some countries and in some jurisdictions the law might 28:30.500 --> 28:34.320 not be entirely clear on that; they might say there are other 28:34.321 --> 28:36.891 stakeholders. But, in the purest form--and 28:36.885 --> 28:40.925 this is the form that we have in the United States--the company 28:40.928 --> 28:42.948 exists for the shareholders. 28:42.950 --> 28:46.900 They're the ones--there are other people who have contracts 28:46.904 --> 28:49.364 with the company, like the employees, 28:49.358 --> 28:52.288 but the employees are not shareholders; 28:52.289 --> 28:55.749 they are receiving salary or something else. 28:55.750 --> 28:59.350 The important thing for the corporation is to live up to any 28:59.350 --> 29:00.510 promises it made. 29:00.509 --> 29:02.429 It has to live up to its promises. 29:02.430 --> 29:06.520 The purpose of the corporation is the shareholders. 29:06.519 --> 29:11.609 This is a capitalist idea that might sometimes sound wrong. 29:11.609 --> 29:13.859 You might say, why should a company exist for 29:13.858 --> 29:14.828 the shareholders? 29:14.829 --> 29:19.169 Well, the concept here is that it's a good business model. 29:19.170 --> 29:22.430 People do need money and they go into business to make money; 29:22.430 --> 29:25.780 so let's make it clear, that's what the company is 29:25.782 --> 29:28.212 going to do. It has to behave in an 29:28.213 --> 29:31.143 honorable way for everyone; it has to live up to its 29:31.141 --> 29:32.901 contract. But the company generally 29:32.904 --> 29:36.354 doesn't give to charity; it doesn't contribute to 29:36.347 --> 29:39.017 political campaigns; it shouldn't be, 29:39.024 --> 29:40.884 ideally, doing any of those things. 29:40.880 --> 29:44.900 It should be trying to get money back to the shareholders. 29:44.900 --> 29:47.790 If you ever serve on a board of directors--this is the thing 29:47.788 --> 29:50.578 that I want you to remember because many of you will serve 29:50.578 --> 29:51.898 on boards of directors. 29:51.900 --> 29:58.040 When you sign on to a job on the board, you are signing on to 29:58.041 --> 30:04.391 a solemn responsibility and that responsibility is to treat all 30:04.388 --> 30:10.528 shareholders equally and fairly and make money for them. 30:10.529 --> 30:14.589 Then you're not supposed to ever do anything that's not 30:14.588 --> 30:17.518 honest or not living up to contracts, 30:17.519 --> 30:21.819 but your purpose is only one purpose: it's the shareholder. 30:21.819 --> 30:27.159 When you serve on a board, you are in a fiduciary role; 30:27.160 --> 30:31.080 you are there to protect shareholders and that's the 30:31.081 --> 30:33.921 concept. It's for-profit and the theory 30:33.922 --> 30:37.932 that we have in capitalist countries is that this is a good 30:37.928 --> 30:40.048 model. There are non-profits, 30:40.045 --> 30:43.985 fine, but we--a lot of the stuff that has to be done for an 30:43.988 --> 30:47.458 economy is only going to get done through for-profit 30:47.456 --> 30:50.896 corporations. So let's make it clear--let's 30:50.895 --> 30:55.705 make it unambiguous--people who are on boards or are managers of 30:55.708 --> 30:59.158 these companies, they can give their personal 30:59.163 --> 31:03.393 money to charities but they themselves are obligated to make 31:03.385 --> 31:06.055 money. It's not a vice. 31:06.059 --> 31:09.849 This is the concept that is in the law and the reason we have 31:09.845 --> 31:13.495 it in the law is that it works to produce prosperity and to 31:13.504 --> 31:16.424 produce the things we need, like clothes, 31:16.422 --> 31:18.942 medical service, homes, whatever. 31:18.940 --> 31:22.740 So that's why we do it and there's no shame in pursuing 31:22.740 --> 31:26.260 profits and getting it out to your shareholders. 31:26.259 --> 31:30.519 Now ultimately, the purpose of investing in a 31:30.515 --> 31:36.075 share is to get the dividends; that's the whole named purpose 31:36.082 --> 31:37.732 of the corporation. 31:37.730 --> 31:44.530 I might add though that there are other ways that--I may have 31:44.534 --> 31:47.374 said that too narrowly. 31:47.369 --> 31:50.109 Traditionally, you buy stocks to get 31:50.110 --> 31:52.440 dividends; that's the reason. 31:52.440 --> 31:57.430 I want to be careful about qualifying that. 31:57.430 --> 32:00.660 First of all, a lot of people don't seem to 32:00.660 --> 32:04.810 even grasp that basic point that you buy stocks for the 32:04.813 --> 32:07.993 dividends. A lot of people think, 32:07.993 --> 32:09.813 I will buy stocks. 32:09.810 --> 32:11.320 But why do people buy stocks? 32:11.319 --> 32:14.269 They'll buy stocks because they think price is going to go up 32:14.267 --> 32:15.787 and make them a lot of money. 32:15.789 --> 32:17.539 They can sell it at an advantage. 32:17.539 --> 32:20.339 That's what most people think, right? 32:20.340 --> 32:22.080 Do I buy stocks for dividends? 32:22.079 --> 32:24.709 Some people don't even know what a dividend is, 32:24.714 --> 32:28.154 they just think of stock as something whose price goes up. 32:28.150 --> 32:31.640 It doesn't make sense to think that the price of anything would 32:31.638 --> 32:33.718 go up if that's all there is to it. 32:33.720 --> 32:37.450 Why would people pay any price for stocks if there weren't some 32:37.447 --> 32:38.827 way to get money out? 32:38.829 --> 32:41.659 The ultimate thing is the dividend; 32:41.660 --> 32:44.480 the dividends, even though a lot of people 32:44.483 --> 32:48.693 forget the dividends and don't realize how important they are, 32:48.685 --> 32:51.435 they are actually the driving force. 32:51.440 --> 32:55.980 I wanted to just show you a plot that you already saw in 32:55.984 --> 33:00.534 your--if you looked on the spreadsheet that I had up. 33:00.529 --> 33:06.579 This is the stock market for the United States; 33:06.579 --> 33:08.569 it's the Standard & Poor Composite. 33:08.569 --> 33:13.459 In 1957, they reformulated it and they called it the Standard 33:13.455 --> 33:17.865 & Poor 500, but I'm using their long 33:17.871 --> 33:24.441 theories, back to 1871, so I can't call it the 500; 33:24.440 --> 33:25.890 I'm calling it the Composite. 33:25.890 --> 33:34.380 What this is is the price of a portfolio of shares in U.S. 33:34.382 --> 33:38.902 companies. It's kind of like the average 33:38.895 --> 33:44.345 price of a share adjusted for splits because you don't want 33:44.346 --> 33:49.136 the--obviously when they do a two-for-one split, 33:49.140 --> 33:51.240 the price falls in half and that's meaningless, 33:51.238 --> 33:52.878 so you want to correct for splits. 33:52.880 --> 33:57.680 S&P corrects for splits and follows the price of a share. 33:57.680 --> 34:01.140 Now unfortunately, the same companies are not 34:01.141 --> 34:05.861 around--the companies that we had in 1871, hardly any of them 34:05.860 --> 34:07.670 even exist anymore. 34:07.670 --> 34:11.550 What they do is they're pricing a portfolio up here and they 34:11.553 --> 34:13.663 keep substituting in new ones. 34:13.659 --> 34:16.799 There's an index committee that keeps bringing in new shares 34:16.804 --> 34:18.834 when new companies become important; 34:18.829 --> 34:22.579 they try to get the 500 representative of the most 34:22.579 --> 34:25.409 companies in the world--in the U.S. 34:25.409 --> 34:29.639 You can see that's what the price has done. 34:29.639 --> 34:34.309 There are also the earnings per share. 34:34.310 --> 34:35.820 What are earnings per share? 34:35.820 --> 34:39.970 Earnings are something that accountants have generated and 34:39.969 --> 34:43.829 they've been doing it all the way back to 1871--it's a 34:43.828 --> 34:47.828 venerable concept; it's how much money the company 34:47.832 --> 34:51.012 made this year, if it's annual earnings. 34:51.010 --> 34:57.170 The price of a share is the price of the ownership of that 34:57.166 --> 35:00.186 earnings' stream, forever. 35:00.190 --> 35:04.000 If I buy a share I'm in with everyone else who owns the 35:03.995 --> 35:07.725 company and I have a claim on the earnings' stream, 35:07.730 --> 35:11.650 but the earnings' stream is a year-by-year thing. 35:11.650 --> 35:14.660 It just tells you how well they did in that given year. 35:14.659 --> 35:19.509 You can see that the stock market has been more volatile 35:19.510 --> 35:24.980 than the earnings and the price of a share is many times higher 35:24.977 --> 35:27.797 than the earnings per share. 35:27.800 --> 35:31.960 So, typically the ratio of price-to-earnings has been about 35:31.962 --> 35:34.472 fifteen. That means that people will pay 35:34.469 --> 35:37.009 up front for about fifteen years' earnings. 35:37.010 --> 35:44.490 35:44.489 --> 35:48.939 Earnings and dividends are different; 35:48.940 --> 35:53.050 earnings is the money that the company made in a given year. 35:53.050 --> 35:55.890 How do they know what they made? 35:55.889 --> 35:59.889 That's a complicated thing that accountants figure out and 35:59.889 --> 36:03.819 accountants find it difficult to define the earnings of a 36:03.818 --> 36:06.328 company, but they do something and they 36:06.329 --> 36:07.609 come up with a number. 36:07.610 --> 36:10.560 It may surprise the company directors how much we made or 36:10.557 --> 36:13.187 how little we made according to the accountants. 36:13.190 --> 36:17.760 The dividend is something much more concrete. 36:17.760 --> 36:21.500 This is what they actually send out--this is cash sent out to 36:21.503 --> 36:23.963 shareholders. "Earnings" is kind of a 36:23.959 --> 36:27.529 theoretical concept that accountants work on and it can 36:27.527 --> 36:31.027 go up and down depending on adjustments they make. 36:31.030 --> 36:35.240 They might decide that we have some investment over there that 36:35.236 --> 36:39.026 we just lost money on and we should take a write off for 36:39.029 --> 36:41.149 that. The management might say, 36:41.153 --> 36:44.643 well what do you mean we didn't lose any money this year? 36:44.639 --> 36:46.249 But the accountants thought we did. 36:46.250 --> 36:48.670 So that's earnings. 36:48.670 --> 36:52.360 Dividends is very concrete, it's what they send out. 36:52.360 --> 36:57.320 Here is the price-earnings ratio for the U.S. 36:57.320 --> 37:02.770 stock market from 1881 to the present--this is also on that 37:02.769 --> 37:06.809 spreadsheet that you have on the website. 37:06.809 --> 37:11.979 You can see that I'm saying about fifteen--fifteen times 37:11.981 --> 37:15.651 earnings is typical, but we're in a high 37:15.648 --> 37:18.938 price-to-earnings scenario now. 37:18.940 --> 37:22.650 It goes up and down depending on the outlook for earnings and 37:22.649 --> 37:24.009 maybe other factors. 37:24.010 --> 37:26.500 The red line is long-term interest rates, 37:26.504 --> 37:29.314 but I won't talk more about that right now. 37:29.309 --> 37:32.389 The earnings is a measure of the value of the company and 37:32.387 --> 37:35.687 typically they've been valued at something like fifteen times 37:35.685 --> 37:38.165 earnings. When the price-earnings ratio 37:38.173 --> 37:41.113 gets high like it did in 1929 people get antsy. 37:41.110 --> 37:43.520 They thought, oh my God, the price earnings 37:43.520 --> 37:44.840 ratio is thirty-five. 37:44.840 --> 37:47.910 Again, this is price divided by ten-year earnings, 37:47.907 --> 37:49.407 not one-year earnings. 37:49.410 --> 37:50.530 This is what I do. 37:50.530 --> 37:53.350 We had an extraordinarily high price-to-earnings ratio 37:53.347 --> 37:56.637 representing a lot of optimism in the '20s for the stock market 37:56.644 --> 37:59.894 and then it corrected and went abruptly downward--that was The 37:59.887 --> 38:01.107 Great Depression. 38:01.110 --> 38:04.250 We had a similar, even higher price-to-earnings 38:04.252 --> 38:08.352 ratio of about forty-six at the peak in 2000 and it corrected 38:08.351 --> 38:11.251 way down. The price reflects--really, 38:11.246 --> 38:15.256 when you buy a share of a company you own it forever. 38:15.260 --> 38:18.850 You will be--you are entitled to receiving the dividends that 38:18.845 --> 38:22.485 are paid out of earnings for the rest of your life and you can 38:22.491 --> 38:26.021 give it to your children and maybe in two hundred years from 38:26.017 --> 38:29.847 now it'll be worth a lot; probably not, but it might be. 38:29.849 --> 38:33.229 It probably won't even in exist in fifty years but it will be 38:33.233 --> 38:36.623 bought by some other company and it will still have value and 38:36.617 --> 38:38.137 will still be going up. 38:38.140 --> 38:43.140 That's the price-earnings ratio. 38:43.139 --> 38:45.479 The earnings, you understand, 38:45.482 --> 38:49.832 are kind of a theoretical concept but dividend is the 38:49.831 --> 38:52.091 money that we send out. 38:52.090 --> 38:55.010 How does the company decide on dividends? 38:55.010 --> 38:59.170 That's again up to the board to decide or they can set up a 38:59.167 --> 39:02.247 committee on the board that would decide, 39:02.250 --> 39:05.830 but ultimately, that's a major decision to send 39:05.833 --> 39:09.723 out dividends. Typically, young companies do 39:09.722 --> 39:11.912 not send out dividends. 39:11.909 --> 39:14.789 If you set up a company, you don't want to pay a 39:14.792 --> 39:18.292 dividend for a while because you need the money and you're 39:18.288 --> 39:22.028 reinvesting it in the company and people will understand. 39:22.030 --> 39:24.890 They don't expect to get their money out of an investment right 39:24.887 --> 39:26.967 away. As a company matures, 39:26.974 --> 39:31.934 then they typically feel that it's time to pay a dividend. 39:31.929 --> 39:35.869 The S&P 500 is 500 companies, who are major 39:35.866 --> 39:40.996 companies, so these tend to be mature companies and they tend 39:41.002 --> 39:44.342 to be in the dividend-paying stage. 39:44.340 --> 39:57.400 The question then is--the payout ratio is dividends over 39:57.400 --> 40:03.100 earnings, I say Div/E. 40:03.099 --> 40:05.649 I have the payout ratio for the United States; 40:05.650 --> 40:11.550 that's the payout ratio going back to 1871. 40:11.550 --> 40:16.920 There are some spikes up like, for example, 40:16.916 --> 40:23.046 in--what year--that was 1921 maybe--this year, 40:23.050 --> 40:28.780 this is 1932 or 1933--the companies were paying out 160% 40:28.781 --> 40:32.221 of their earnings as dividends. 40:32.219 --> 40:35.219 You might say, well what's going on here? 40:35.220 --> 40:37.040 It was The Depression. 40:37.039 --> 40:42.139 What was actually happening was, The Depression was killing 40:42.137 --> 40:45.497 these companies; they weren't making any money, 40:45.504 --> 40:48.784 but they didn't want to cut their dividends because they 40:48.775 --> 40:52.755 were afraid that if they cut the dividend people would be upset. 40:52.760 --> 40:55.460 They're trying--maybe they did cut it but they didn't cut it 40:55.459 --> 40:58.109 too much, so that means that they were paying out more than 40:58.113 --> 40:59.123 they were earning. 40:59.119 --> 41:01.159 That's what typically happens in these spikes; 41:01.160 --> 41:04.870 it was a crisis. Now, there's also a trend 41:04.871 --> 41:07.851 downward. They used to pay out typically 41:07.853 --> 41:11.363 like 80% of their earnings but it's been gradually going 41:11.361 --> 41:14.041 downward and now it's down to like 40%. 41:14.039 --> 41:16.939 That's a cultural thing, I would say; 41:16.940 --> 41:20.310 it's that companies now are wanting to keep the money. 41:20.309 --> 41:25.459 It may have to do with the fact that people today don't seem to 41:25.458 --> 41:30.608 be as focused on dividends and so that means that companies are 41:30.607 --> 41:34.507 more able to reinvest earnings and not pay. 41:34.510 --> 41:38.950 This is the dividend-price ratio back to 1871. 41:38.949 --> 41:44.759 Back in the late nineteenth century the dividend price ratio 41:44.759 --> 41:46.629 was typically 5%. 41:46.630 --> 41:50.140 I think it was clearer in those days. 41:50.139 --> 41:53.079 In terms of just general investing culture--and we're 41:53.080 --> 41:56.420 behavioral in our attitude--it was clearer that you bought a 41:56.416 --> 41:57.996 stock to get a dividend. 41:58.000 --> 42:00.360 Stocks were kind of different in those days. 42:00.360 --> 42:03.220 They were more like railroads or steel companies and it was 42:03.221 --> 42:05.851 just understood. If someone were recommending 42:05.853 --> 42:09.093 you a stock, you'd first say, what is its dividend? 42:09.090 --> 42:11.320 And if someone said, it's 4%, you'd say, 42:11.321 --> 42:14.531 well that's kind of meager, I want a better dividend than 42:14.525 --> 42:17.945 that. Now, people don't seem to be 42:17.952 --> 42:21.842 focused on them. In another sense, 42:21.835 --> 42:29.415 they're more willing to entrust the money back to the board of 42:29.424 --> 42:36.894 directors to decide on when and whether to pay dividends. 42:36.889 --> 42:40.529 Now the other thing is, there are other ways to get 42:40.528 --> 42:44.748 money out of a company without paying a dividend and one of 42:44.749 --> 42:46.859 them is stock repurchase. 42:46.860 --> 42:52.600 42:52.600 --> 42:54.800 There's also liquidation. 42:54.800 --> 42:57.730 Let me mention liquidation or sale of company. 42:57.730 --> 43:02.560 43:02.559 --> 43:06.599 I'll talk about this--the company doesn't ever have to pay 43:06.598 --> 43:09.028 a dividend. All it can do is keep piling in 43:09.033 --> 43:11.873 the money and accumulating it and then someone will buy the 43:11.866 --> 43:14.796 whole company and then all of the shareholders will be bought 43:14.796 --> 43:16.306 out at a termination date. 43:16.309 --> 43:21.609 That's one way that a--but often, when companies are bought 43:21.614 --> 43:26.924 out, they don't give them cash they give them shares in the 43:26.918 --> 43:28.928 acquiring company. 43:28.929 --> 43:32.289 So, then you would be relying on getting dividends from the 43:32.291 --> 43:33.451 acquiring company. 43:33.449 --> 43:37.459 I don't emphasize this cash sale of a company, 43:37.464 --> 43:40.234 but it does happen sometimes. 43:40.230 --> 43:46.290 The other thing that a company can do to get money out is share 43:46.292 --> 43:51.672 repurchase--a stock repurchase or a share repurchase. 43:51.670 --> 43:56.030 It's perfectly--this sometimes surprises people when they first 43:56.025 --> 43:58.695 think about it. You, as an individual, 43:58.702 --> 44:02.212 can call up your broker and say, I want to buy Google 44:02.206 --> 44:05.566 shares. But Larry Paige at Google can 44:05.573 --> 44:11.433 call up a broker--he better get the board's permission--somebody 44:11.425 --> 44:16.805 at Google can call up a broker and make the same statement: 44:16.812 --> 44:19.972 we want to buy Google shares. 44:19.969 --> 44:23.719 You might say, well how can Google buy Google? 44:23.720 --> 44:26.980 "Why not?" is the answer. 44:26.980 --> 44:28.970 Why shouldn't Google buy Google shares? 44:28.969 --> 44:32.309 Then you might--well let me ask you this, what would happen if 44:32.313 --> 44:34.783 Google decided to buy up all of its shares? 44:34.780 --> 44:37.130 Could that happen? 44:37.130 --> 44:42.510 44:42.510 --> 44:47.920 I'm the CEO of Google and I call the broker and I say, 44:47.919 --> 44:51.389 how many shares are outstanding? 44:51.389 --> 44:53.209 Like 100,000,000 or some–no, 44:53.213 --> 44:56.203 it wouldn't be 100,000,000--we know the price is $500 a 44:56.196 --> 44:59.066 share--well, I could figure it out more or less. 44:59.070 --> 45:04.470 The answer is, you--let me put it this way. 45:04.469 --> 45:06.659 Let me see if this will help you understand. 45:06.659 --> 45:11.459 Suppose Larry Paige calls up and says, I'd like to buy all of 45:11.455 --> 45:14.485 the Google shares, and the broker says, 45:14.492 --> 45:17.212 alright I'll get them for you. 45:17.210 --> 45:21.270 Then he comes back and says, I managed to get all but one 45:21.266 --> 45:25.756 hundred shares and there's this one guy--this Yale student--who 45:25.757 --> 45:29.597 owns one hundred shares of Google stock and I'm having 45:29.597 --> 45:32.057 trouble getting him to sell. 45:32.059 --> 45:35.199 So, the broker calls you up and says, Google wants to buy all of 45:35.197 --> 45:36.937 its shares--I'm being silly here. 45:36.940 --> 45:41.690 What do you say to the broker then? 45:41.690 --> 45:45.790 So, the broker calls you up and says, you're the last guy, 45:45.785 --> 45:49.805 you have the last one hundred shares in Google and Google 45:49.809 --> 45:53.689 wants to buy them and we'll give you $500 a share. 45:53.690 --> 45:55.270 So what do you say? 45:55.270 --> 46:01.200 You say no. Actually, I have a better 46:01.204 --> 46:04.754 thing, you say, call Larry Paige and tell him 46:04.750 --> 46:08.780 he's fired because I realize I own the company. 46:08.780 --> 46:12.470 If I own the last one hundred shares, it's all mine; 46:12.469 --> 46:15.149 I don't have to take any--I can do whatever I want. 46:15.150 --> 46:18.810 The last shareholder--so a company can't buy all of its 46:18.805 --> 46:22.725 shares but it can buy some of its shares and that's another 46:22.732 --> 46:25.442 way to get money out of the company. 46:25.440 --> 46:31.570 It's a little different if they buy--suppose you own a hundred 46:31.574 --> 46:35.804 shares and they declare a 5% cash dividend, 46:35.798 --> 46:40.718 then you get $5. But what if the company buys 46:40.719 --> 46:43.109 back 5% of its shares? 46:43.110 --> 46:45.760 What happens then? 46:45.760 --> 46:52.980 Well, the company is still paying out money in the same 46:52.981 --> 46:57.931 amount total, but it's coming out in a 46:57.929 --> 47:02.969 different form; it's coming as a share 47:02.974 --> 47:06.704 repurchase. It's changing the number of 47:06.699 --> 47:10.719 shares outstanding, so the value of the company 47:10.720 --> 47:15.610 declines by the same amount; it has to, as if they had just 47:15.606 --> 47:18.046 paid a dividend. If they're sending out money, 47:18.048 --> 47:20.548 the value of the company has to go down by whatever they sent 47:20.548 --> 47:22.208 out. With share repurchase, 47:22.210 --> 47:25.760 the number of shares goes down, and if they don't do share 47:25.762 --> 47:28.942 repurchase the number of shares doesn't go down. 47:28.940 --> 47:32.860 So in a sense, it's all the same to me as a 47:32.858 --> 47:38.078 shareholder whether they pay dividends or they repurchase 47:38.083 --> 47:41.033 shares. I don't know how clear that all 47:41.030 --> 47:43.240 was; let me just write this down. 47:43.240 --> 47:45.690 This idea has a name. 47:45.690 --> 47:50.980 Two authors, both who won the Nobel Prize in 47:50.977 --> 47:58.107 finance, Franco--and I know I was his advisee in my PhD, 47:58.110 --> 48:00.580 so I learned how to pronounce his 48:00.580 --> 48:05.210 name–Modigliani--because in Italian you don't pronounce 48:05.213 --> 48:09.303 the "g," although I tend to say 48:09.302 --> 48:16.922 Modigliani just to be understood--and Merton Miller. 48:16.920 --> 48:23.280 Modigliani is one of the authors of your textbook along 48:23.282 --> 48:27.112 with Fabozzi. Modigliani and Miller wrote a 48:27.108 --> 48:30.798 famous article arguing that--what I just said--I just 48:30.798 --> 48:33.848 tried to say it in very intuitive terms. 48:33.849 --> 48:45.649 They said, dividend policy is irrelevant. 48:45.650 --> 48:51.340 Although, they do put it in a qualifier that it could matter 48:51.335 --> 48:54.705 for tax reasons. In fact, you have to put that 48:54.706 --> 48:58.196 qualifier on just about anything you say in finance because the 48:58.204 --> 49:01.764 tax system is infinitely complex and every country has different 49:01.759 --> 49:04.329 taxes, different states have different 49:04.329 --> 49:06.859 taxes. There's nothing you can say 49:06.859 --> 49:09.799 boldly in finance if you allow taxes. 49:09.800 --> 49:11.970 Well, let's just disregard taxes. 49:11.969 --> 49:17.809 When Modigliani--this sounds like a very strong proposition 49:17.809 --> 49:20.729 about dividend irrelevance. 49:20.730 --> 49:27.050 What they're saying is that of course lots of things that a 49:27.053 --> 49:32.943 board of directors decides to do are not irrelevant; 49:32.940 --> 49:35.840 it's highly relevant to the future of the company. 49:35.840 --> 49:39.640 But real things matter, like if the company decides to 49:39.643 --> 49:41.943 build that new plant in Akron. 49:41.940 --> 49:45.320 That matters for the company because if the plant works out 49:45.322 --> 49:48.182 to be a success, then the company will do well. 49:48.179 --> 49:51.589 They're spending money on concrete, and bricks, 49:51.591 --> 49:54.711 and machinery, and they could be doing that 49:54.706 --> 49:59.226 wisely or unwisely and that's beyond finance to evaluate. 49:59.230 --> 50:03.650 What Modigliani and Miller said, if it's pure dividend 50:03.646 --> 50:06.976 policy, then it is totally irrelevant; 50:06.980 --> 50:09.960 it means nothing, so companies can do whatever 50:09.963 --> 50:11.823 they please--I don't care. 50:11.820 --> 50:15.260 You, as a stockholder--I don't care what they do. 50:15.260 --> 50:19.060 The reason Modigliani and Miller said that is that they 50:19.055 --> 50:22.915 were thinking that if the dividend policy is going to be 50:22.921 --> 50:27.351 changed without changing any of the activities of the firm, 50:27.349 --> 50:31.429 keeping it a purely financial change, then it must be that 50:31.426 --> 50:35.716 they're switching from dividends to stock repurchase or stock 50:35.717 --> 50:37.717 repurchase to dividends. 50:37.719 --> 50:42.249 You see, you can keep the operations the same whether or 50:42.250 --> 50:46.130 not you pay a dividend, if choosing not to pay a 50:46.125 --> 50:50.585 dividend means substituting stock repurchase for dividend. 50:50.590 --> 50:54.890 So I'm going to build that plant in Akron, 50:54.890 --> 51:01.080 whether I pay a dividend or not, because if I need to cut my 51:01.080 --> 51:07.370 dividend in order to get the money to build the plant I would 51:07.374 --> 51:11.784 also be cutting my stock repurchase. 51:11.780 --> 51:14.500 One way or the other it doesn't--it all comes out to the 51:14.497 --> 51:16.537 same thing. Let me put it in the simplest 51:16.538 --> 51:18.338 way. I think the simplest way to 51:18.339 --> 51:21.629 understand Modigliani-Miller proposition is the following: 51:21.632 --> 51:24.772 imagine that we, as a board, decided to pay a 51:24.765 --> 51:26.505 dividend of $5 a share. 51:26.510 --> 51:30.460 Let's talk in the old days about sending checks out, 51:30.464 --> 51:33.344 alright? We're going to send a letter to 51:33.343 --> 51:37.143 all our shareholders and say, we have decided to pay a $5 51:37.144 --> 51:41.424 dividend and so you're about to approve this at the meeting. 51:41.420 --> 51:43.890 We approve a letter--the letter's going to say, 51:43.886 --> 51:46.456 we're making money here's your dividend check. 51:46.460 --> 51:49.010 Then someone says, hey why don't we just change 51:49.012 --> 51:51.502 it? Why don't we say the same $5 51:51.504 --> 51:54.354 check is included but, in the letter, 51:54.350 --> 51:56.960 let's say something different? 51:56.960 --> 52:03.010 Let's say this is a repurchase of some of your shares at market 52:03.005 --> 52:08.655 price, sending the same check, so what's the difference? 52:08.659 --> 52:12.259 Well, I'll ask you, what difference does it make? 52:12.260 --> 52:15.220 Suppose you get a letter from your company saying, 52:15.217 --> 52:18.717 congratulations here's a $5 dividend and here's a check for 52:18.719 --> 52:20.529 $5 if you owned one share. 52:20.530 --> 52:23.900 Or the company says, congratulations we're 52:23.902 --> 52:29.002 repurchasing 2% of your shares and here's a check for $5 to pay 52:29.003 --> 52:31.063 you for those shares. 52:31.059 --> 52:33.679 And by the way, we're doing that with all 52:33.680 --> 52:35.870 shares. Well, if you think about it, 52:35.865 --> 52:38.025 it doesn't make any difference to me. 52:38.030 --> 52:41.280 It doesn't matter what that letter says--I can crumple it up 52:41.284 --> 52:43.164 and throw it in the wastebasket. 52:43.160 --> 52:44.920 I don't--I want the $5 check. 52:44.920 --> 52:49.640 If they're paying me by sending money and calling it a dividend 52:49.635 --> 52:54.345 it's the same as if they say they're repurchasing my shares. 52:54.349 --> 52:57.219 Because it's--repurchasing my shares, if they do it for 52:57.219 --> 52:59.079 everybody, doesn't mean anything. 52:59.079 --> 53:02.549 I'm getting--we're all lowering--all of our shares are 53:02.546 --> 53:04.636 going down by the same amount. 53:04.639 --> 53:09.479 So, that's the basic insight in Modigliani and Miller, 53:09.482 --> 53:13.502 that share repurchase and dividend are really 53:13.502 --> 53:16.662 interchangeable; it's just all a conceptual 53:16.657 --> 53:19.737 difference. This kind of took people by 53:19.743 --> 53:21.863 surprise. It's kind of--it should be 53:21.860 --> 53:23.430 obvious, I'm making it so simple. 53:23.429 --> 53:26.349 I could write some mathematics to try and--but I think it's so 53:26.353 --> 53:27.363 simple and obvious. 53:27.360 --> 53:30.880 You just have to keep remembering that all that 53:30.877 --> 53:35.617 matters for a company--for you as a--your interest in a company 53:35.619 --> 53:40.589 depends on your shares divided by the total number of shares. 53:40.590 --> 53:43.580 In a stock repurchase, if they repurchase everybody's 53:43.584 --> 53:47.044 shares--the same proportion--it doesn't affect that ratio. 53:47.039 --> 53:51.209 So, you don't care what the letter says--whether it says 53:51.209 --> 53:53.559 dividend or stock repurchase. 53:53.559 --> 53:58.819 Why would a company want to do one or the other? 53:58.820 --> 54:00.820 Well, Modigliani and Miller are leaving the room; 54:00.820 --> 54:02.810 they say it doesn't matter. 54:02.809 --> 54:06.269 If you ask them why a dividend payout policy has 54:06.269 --> 54:10.759 changed--there's a famous Miller quote--he calls it a "neutral 54:10.759 --> 54:11.789 mutation," 54:11.790 --> 54:19.000 54:19.000 --> 54:22.470 as a reference to evolutionary biology, that sometimes 54:22.465 --> 54:25.925 mutations are neither advantageous nor deleterious. 54:25.929 --> 54:31.079 The genome starts piling on mutations that mean nothing; 54:31.079 --> 54:34.739 that's how they date the branches of the genome, 54:34.736 --> 54:38.466 by looking at the number of neutral mutations. 54:38.469 --> 54:41.789 He said all this--this thing that I have up here--well the 54:41.785 --> 54:44.335 previous slide, showing the dividend earnings 54:44.344 --> 54:48.284 ratio--it's just cultural; it means nothing because, 54:48.282 --> 54:51.702 to some extent, what's not shown in that 54:51.702 --> 54:54.862 diagram was the stock repurchase. 54:54.860 --> 55:01.530 I want then finally to talk about Modigliani-Miller and 55:01.534 --> 55:03.954 debt. Now, I didn't talk too much 55:03.950 --> 55:05.950 about debt yet. Before I talk, 55:05.952 --> 55:10.282 I just want to say one more thing about Modigliani-Miller 55:10.282 --> 55:13.532 and dividend--irrelevance of dividends. 55:13.530 --> 55:19.030 There is a possible correction to be made due to taxes. 55:19.030 --> 55:24.400 When Modigliani and Miller wrote, there was a differential 55:24.395 --> 55:28.815 tax rate between dividends and capital gains. 55:28.820 --> 55:33.750 It was--Modigliani and Miller said back then--this was thirty 55:33.749 --> 55:38.269 or forty years ago--that companies should really not pay 55:38.268 --> 55:43.528 dividends because dividends were then taxed at a higher rate than 55:43.526 --> 55:48.596 capital gains. You don't want to give your 55:48.599 --> 55:51.139 shareholders taxes. 55:51.139 --> 55:54.799 You should, in your fiduciary duties as a board member, 55:54.803 --> 55:57.723 be trying to help them lower their taxes. 55:57.719 --> 56:01.869 It doesn't say that in the state law but that would be 56:01.866 --> 56:03.506 inferred as a duty. 56:03.510 --> 56:07.380 So, you would avoid paying dividends and, 56:07.375 --> 56:12.685 therefore, switch to share repurchase as your method. 56:12.690 --> 56:16.280 It took decades for Modigliani-Miller to kind of 56:16.276 --> 56:18.136 sink in. As you can see, 56:18.136 --> 56:21.276 part of the reason why the dividend-earnings 56:21.279 --> 56:24.349 ratio--especially in more recent years, 56:24.349 --> 56:28.949 since 1990--has been declining is that corporations were trying 56:28.948 --> 56:33.468 to somewhat ease the tax burden on their shareholders by doing 56:33.473 --> 56:36.073 repurchase instead of dividend. 56:36.070 --> 56:42.730 However, that all changed in 2003 with the Jobs and Growth 56:42.732 --> 56:48.902 Tax Reconciliation Act of 2003, which cut the rate of taxation 56:48.895 --> 56:53.195 of dividends to 15%--the same rate that capital gains are 56:53.198 --> 56:54.988 taxed. There is now no 56:54.985 --> 56:58.335 preference--well it could be--there are lots of 56:58.344 --> 57:02.584 complexities in the tax law but, basically, dividend policy 57:02.579 --> 57:04.769 really is irrelevant now. 57:04.769 --> 57:08.599 If there's no tax advantage to one over the other it is 57:08.600 --> 57:10.090 completely neutral. 57:10.090 --> 57:16.750 The other thing that I want to say about Modigliani and Miller 57:16.750 --> 57:19.590 is about corporate debt. 57:19.590 --> 57:33.380 57:33.380 --> 57:37.490 I talked about a company as having only shares outstanding, 57:37.488 --> 57:40.178 but they also have debt outstanding. 57:40.180 --> 57:42.680 So, a company can borrow money. 57:42.679 --> 57:48.979 If a company borrows a lot of money it's called "leveraged." 57:48.980 --> 57:57.230 Leverage is measured by the debt-equity ratio. 57:57.230 --> 58:03.160 Now, D here stands for debt; a minute ago I was using Div to 58:03.156 --> 58:05.596 stand for dividends. 58:05.599 --> 58:10.979 They both start with the letter D but they're very different 58:10.977 --> 58:13.977 concepts. The debt of a company is the 58:13.978 --> 58:18.188 amount of money it owes either to banks, or to bond holders, 58:18.189 --> 58:21.829 or to note holders, or commercial paper holders; 58:21.830 --> 58:25.230 these are fixed incomes. 58:25.230 --> 58:27.050 In other words, they are not shares in the 58:27.054 --> 58:31.234 company. When a company becomes 58:31.232 --> 58:37.342 leveraged, it then becomes riskier. 58:37.340 --> 58:44.130 The company becomes riskier because the earnings they have 58:44.130 --> 58:49.610 available after paying interest on the debt, 58:49.610 --> 58:55.520 or repayment of principle of the debt, is what they have 58:55.524 --> 58:58.324 available for dividends. 58:58.320 --> 59:05.170 If debt becomes high relative to their revenue stream then the 59:05.168 --> 59:09.208 company is in a riskier situation. 59:09.210 --> 59:18.090 There's another Modigliani-Miller theorem about 59:18.091 --> 59:27.361 debt, which is about debt irrelevance as well. 59:27.360 --> 59:30.640 That sounds funny, but in a sense, 59:30.636 --> 59:36.986 that is--we have to define the sense in which it's irrelevant. 59:36.989 --> 59:42.239 It certainly isn't irrelevant to the price of a share. 59:42.239 --> 59:47.899 The more money a company borrows the more risky the share 59:47.899 --> 59:52.359 becomes. It's just like if you buy a 59:52.357 --> 1:00:00.017 house and you buy - a lot of people are very leveraged now. 1:00:00.019 --> 1:00:05.029 They might put only 10% down on a house, so you buy a house for 1:00:05.030 --> 1:00:07.940 $300,000 and you put $30,000 down; 1:00:07.940 --> 1:00:13.360 that's an investment of $30,000 but it's highly risky because 1:00:13.361 --> 1:00:18.061 you are very leveraged when you only put 10% down. 1:00:18.059 --> 1:00:21.719 Suppose the home price falls by only 10%--in fact, 1:00:21.715 --> 1:00:24.545 that's what's been happening lately. 1:00:24.550 --> 1:00:29.250 Your $30,000 down payment is completely wiped out because you 1:00:29.248 --> 1:00:32.098 were leveraged. You bought the house for 1:00:32.104 --> 1:00:35.194 $300,000; you sell it for $270,000 that's 1:00:35.192 --> 1:00:38.992 exactly what you owe, so you have nothing left. 1:00:38.990 --> 1:00:42.820 So, leverage brings risk. 1:00:42.820 --> 1:00:48.720 Boards of directors have long agonized over how much to borrow 1:00:48.720 --> 1:00:54.330 and different companies seem to have different cultures. 1:00:54.329 --> 1:01:00.969 For example, Microsoft has avoided borrowing 1:01:00.966 --> 1:01:09.606 any money and they don't believe in debt, so they are not 1:01:09.609 --> 1:01:14.489 leveraged. But other companies get heavily 1:01:14.492 --> 1:01:19.062 indebted and then they can go through big problems. 1:01:19.059 --> 1:01:23.789 It's a very common item of discussion at board meetings 1:01:23.785 --> 1:01:27.285 about how much should our company borrow, 1:01:27.286 --> 1:01:31.396 so they seek advice from financial experts. 1:01:31.400 --> 1:01:36.360 They call in Modigliani and Miller and ask, 1:01:36.362 --> 1:01:39.672 how much should we borrow? 1:01:39.670 --> 1:01:41.640 What do finance theorists say? 1:01:41.639 --> 1:01:46.309 In the extreme case, where we disregard taxes and we 1:01:46.309 --> 1:01:51.159 have to disregard some other problems, we get the same 1:01:51.162 --> 1:01:53.752 answer. Modigliani and Miller said, 1:01:53.753 --> 1:01:56.683 we don't care what you do, do whatever you want--it 1:01:56.684 --> 1:02:00.574 doesn't matter. This is what I want you to 1:02:00.573 --> 1:02:04.063 think about on the problem set. 1:02:04.059 --> 1:02:08.609 Or, maybe speaking about the answer to the questions on the 1:02:08.605 --> 1:02:12.755 Problem Set #4 will help you to think this through. 1:02:12.760 --> 1:02:17.770 The simplest way to see Modigliani-Miller debt 1:02:17.770 --> 1:02:24.450 irrelevance is the following: a company--if you wanted to buy 1:02:24.451 --> 1:02:28.971 a company, you could buy only the shares, 1:02:28.966 --> 1:02:32.026 or equity. Incidentally, 1:02:32.028 --> 1:02:38.268 did I ever--equity equals shares or stock, 1:02:38.268 --> 1:02:44.658 so when I talk about debt-equity ratio, 1:02:44.659 --> 1:02:46.969 I'm talking about the ratio of the value of the company's debt 1:02:46.966 --> 1:02:48.286 to the value of all of its stock. 1:02:48.290 --> 1:02:56.720 1:02:56.719 --> 1:02:59.479 If you wanted to buy a company up and own it yourself 1:02:59.478 --> 1:03:02.708 completely, you could conceive of buying all the shares in the 1:03:02.713 --> 1:03:04.833 company. There are ten million shares 1:03:04.825 --> 1:03:07.455 outstanding--I'm going to buy ten million shares. 1:03:07.460 --> 1:03:09.940 But in a sense, I don't really own the whole 1:03:09.937 --> 1:03:12.527 company yet because the company owes money. 1:03:12.530 --> 1:03:15.180 What if I wanted to buy the whole kit and caboodle--the 1:03:15.177 --> 1:03:17.937 whole operation? I should be buying all the 1:03:17.935 --> 1:03:20.815 equity and all the debt as well, right? 1:03:20.820 --> 1:03:24.460 If the company issued--if I really want to own it and I have 1:03:24.460 --> 1:03:28.100 no--I really wanted to be the tycoon and this is my baby, 1:03:28.099 --> 1:03:30.949 nobody else can get in my backyard; 1:03:30.949 --> 1:03:34.909 I can do whatever I want--you'd have to buy all the equity and 1:03:34.906 --> 1:03:37.886 all the debt. Otherwise, if you don't buy all 1:03:37.886 --> 1:03:41.446 the debt, you still have a problem because those debtors 1:03:41.446 --> 1:03:45.196 can go after you because they are--they're not shareholders 1:03:45.200 --> 1:03:48.890 but they have rights and they could come in and say, 1:03:48.890 --> 1:03:51.460 we don't like what you're doing; we're going to sue you because 1:03:51.461 --> 1:03:53.961 we think that you're doing something contrary to our 1:03:53.962 --> 1:03:55.092 interest as debtors. 1:03:55.090 --> 1:03:58.180 If you really want to buy the company, you buy up all its 1:03:58.183 --> 1:04:00.893 equity--all of its shares--and all of its debt. 1:04:00.889 --> 1:04:05.819 The basic insight about Modigliani and Miller debt 1:04:05.821 --> 1:04:10.851 irrelevance is that, in the absence of taxes or any 1:04:10.854 --> 1:04:15.554 other special thing, the real value of the company 1:04:15.548 --> 1:04:20.178 is going to be unaffected by whether they finance by debt or 1:04:20.184 --> 1:04:24.984 by equity because the real value of a company is determined by 1:04:24.977 --> 1:04:30.317 the cash flow that they generate by the business they're doing. 1:04:30.320 --> 1:04:34.670 So, they are selling widgets or whatever and making money--the 1:04:34.669 --> 1:04:39.089 value of the company is the present value of that cash flow. 1:04:39.090 --> 1:04:43.530 If you want to buy the company you have to buy up all the debt 1:04:43.531 --> 1:04:45.061 and all the equity. 1:04:45.059 --> 1:04:48.539 From the standpoint of a buyer of the whole company, 1:04:48.538 --> 1:04:51.878 what do I care how the ownership of the company is 1:04:51.880 --> 1:04:54.540 divided up between debt and equity? 1:04:54.539 --> 1:04:58.549 I have to buy them all anyway, so I don't care whether 1:04:58.550 --> 1:05:02.940 three-fourths of my money goes to debt or one-fourth of the 1:05:02.939 --> 1:05:04.679 money goes to debt. 1:05:04.679 --> 1:05:06.409 I just want to know the bottom line; 1:05:06.409 --> 1:05:09.279 how much do I have to pay for the whole company? 1:05:09.280 --> 1:05:14.970 The debt irrelevance theory says that it matters for the 1:05:14.968 --> 1:05:21.278 price of a share what a company issues--how much debt it takes 1:05:21.277 --> 1:05:27.377 on--but it doesn't matter for the value of the company. 1:05:27.380 --> 1:05:32.470 There's almost an arithmetic relationship theory that they 1:05:32.468 --> 1:05:35.358 put forth. I'm not going to go through 1:05:35.361 --> 1:05:39.001 their numbers but the value of the company, as a whole, 1:05:39.003 --> 1:05:42.783 is really determined by something outside of finance. 1:05:42.780 --> 1:05:51.710 Again, we have to qualify the debt irrelevance for taxes. 1:05:51.710 --> 1:05:59.260 1:05:59.260 --> 1:06:08.270 So, companies might be concerned with the fact that 1:06:08.270 --> 1:06:18.540 debt is tax-deductible for corporations on their corporate 1:06:18.542 --> 1:06:25.392 profits tax but dividends are not. 1:06:25.389 --> 1:06:30.059 According to Modigliani and Miller, if you add taxes to 1:06:30.060 --> 1:06:33.260 their debt irrelevance proposition, 1:06:33.260 --> 1:06:37.490 it means that companies will want to borrow a lot and the 1:06:37.492 --> 1:06:41.202 real advice they would be giving to Bill Gates is: 1:06:41.196 --> 1:06:43.536 what's the matter with you? 1:06:43.540 --> 1:06:45.980 Why aren't you borrowing money? 1:06:45.980 --> 1:06:52.110 It's tax deductible, whereas dividends are not. 1:06:52.110 --> 1:06:58.270 That would mean that companies should try to push their 1:06:58.270 --> 1:07:05.230 debt-equity ratio up as high as possible given that theory. 1:07:05.230 --> 1:07:07.490 On the other hand, if they do so, 1:07:07.494 --> 1:07:09.904 they may be courting bankruptcy. 1:07:09.900 --> 1:07:14.310 If the company gets too leveraged then there's too high 1:07:14.314 --> 1:07:19.384 a probability that the company will fail and there are costs to 1:07:19.383 --> 1:07:24.223 bankruptcy. The other qualification is 1:07:24.220 --> 1:07:26.720 bankruptcy costs. 1:07:26.719 --> 1:07:30.509 A company, according to Modigliani and Miller, 1:07:30.513 --> 1:07:34.733 has to weigh their tax considerations against their 1:07:34.728 --> 1:07:39.698 bankruptcy costs and get an optimum debt-equity ratio out of 1:07:39.702 --> 1:07:42.152 that. It is an insight that 1:07:42.148 --> 1:07:46.268 Modigliani and Miller are offering the corporations that I 1:07:46.270 --> 1:07:50.030 think they often don't see that the real issue in the 1:07:50.031 --> 1:07:54.371 dividend--both the dividend and the debt policies--are really 1:07:54.370 --> 1:07:56.540 taxes and nothing else. 1:07:56.539 --> 1:08:03.829 The last thing, I just wanted to say--I wanted 1:08:03.829 --> 1:08:12.419 to mention the theory of dividend payout given by John 1:08:12.416 --> 1:08:16.026 Lintner; it's called the Lintner Model 1:08:16.032 --> 1:08:16.842 of Dividends. 1:08:16.840 --> 1:08:21.240 1:08:21.239 --> 1:08:25.409 I'm saying that, unless tax considerations 1:08:25.408 --> 1:08:31.608 intervene, dividend policy is really irrelevant for a firm. 1:08:31.609 --> 1:08:36.679 Maybe Merton Miller is right--these things are "neutral 1:08:36.678 --> 1:08:42.308 mutations" and changes in dividend policy are meaningless. 1:08:42.310 --> 1:08:44.450 But how do they actually do it? 1:08:44.449 --> 1:08:47.959 How do boards and their committees decide how much to 1:08:47.958 --> 1:08:49.508 pay out in dividends? 1:08:49.510 --> 1:08:54.090 John Lintner was a professor at the Harvard Business School, 1:08:54.086 --> 1:08:57.336 who, decades ago, did a survey of people who 1:08:57.340 --> 1:09:01.450 decide on dividends and asked them, what goes on in your mind 1:09:01.450 --> 1:09:05.560 and what do you think about when you decide on dividends? 1:09:05.560 --> 1:09:10.240 He had a long discussion; they said millions of different 1:09:10.242 --> 1:09:11.292 things--it's very hard. 1:09:11.289 --> 1:09:16.609 People who decide on dividends are facing a complicated issue. 1:09:16.609 --> 1:09:20.839 One thing that Merton Miller (sic) distilled from it was that 1:09:20.840 --> 1:09:24.160 people on boards, who decide on dividend payout, 1:09:24.155 --> 1:09:28.035 are very focused on the price of a share and they're worried 1:09:28.041 --> 1:09:29.821 about investor reaction. 1:09:29.819 --> 1:09:33.219 Boards always want to keep their price of a share up 1:09:33.220 --> 1:09:37.090 because if it starts to decline, the company could become a 1:09:37.086 --> 1:09:40.526 takeover target; it's viewed as a failure etc., 1:09:40.528 --> 1:09:43.458 etc. They talked a lot to him about 1:09:43.456 --> 1:09:45.256 investor psychology. 1:09:45.260 --> 1:09:49.430 In a sense, I'm terminating this lecture with another 1:09:49.425 --> 1:09:52.225 triumph for behavioral economics. 1:09:52.229 --> 1:09:55.919 When we think about the theory of dividend or debt we end up 1:09:55.922 --> 1:09:59.052 with irrelevance--it doesn't mean anything--but the 1:09:59.050 --> 1:10:02.680 companies' boards talk about it incessantly and it seems to 1:10:02.680 --> 1:10:04.370 matter a lot to them. 1:10:04.369 --> 1:10:07.619 If you ask them why it matters, they say, well it's pretty 1:10:07.622 --> 1:10:11.222 obvious--it's all their investor psychology that we have to deal 1:10:11.216 --> 1:10:13.396 with. They say things like this: 1:10:13.400 --> 1:10:16.480 if we pay a dividend, then they're going to start 1:10:16.483 --> 1:10:19.023 expecting that. And if we don't pay a dividend 1:10:19.015 --> 1:10:21.165 once, then they're going to say, what's wrong? 1:10:21.170 --> 1:10:23.490 As long as we never start paying a dividend, 1:10:23.488 --> 1:10:26.938 then we're just a young company and nobody asks any questions. 1:10:26.939 --> 1:10:30.929 Then we start paying a dividend and then if we ever have to cut 1:10:30.931 --> 1:10:32.671 it, we're in big trouble. 1:10:32.670 --> 1:10:34.560 The newspaper reporters will start calling, 1:10:34.557 --> 1:10:35.947 why did you cut the dividend? 1:10:35.949 --> 1:10:38.849 You said, you didn't call us up when we weren't paying any 1:10:38.846 --> 1:10:41.686 dividend and now we're still paying more than we used to, 1:10:41.691 --> 1:10:42.861 why all this alarm? 1:10:42.859 --> 1:10:45.639 They said--one of the lessons they were told is, 1:10:45.644 --> 1:10:49.264 never cut a dividend unless you do it as a--you could do a one 1:10:49.257 --> 1:10:50.617 time only dividend. 1:10:50.619 --> 1:10:53.639 Say, we're just doing this once and don't expect it again. 1:10:53.640 --> 1:10:56.600 But if you start paying regular dividends, then you better keep 1:10:56.600 --> 1:10:59.420 doing them or people are going to conclude that something is 1:10:59.418 --> 1:11:02.568 really wrong. They told him that if earnings 1:11:02.569 --> 1:11:07.169 go up--we try to keep a target payout ratio--but if earnings 1:11:07.171 --> 1:11:10.131 suddenly shoot up, we're not going to increase our 1:11:10.129 --> 1:11:12.429 dividends right away because that would set too high an 1:11:12.428 --> 1:11:14.598 expectation and we don't want to have to cut it. 1:11:14.600 --> 1:11:17.840 So if earnings go up a lot, we'll raise our dividends, 1:11:17.843 --> 1:11:19.683 but only part of the way up. 1:11:19.680 --> 1:11:27.020 The model that–I better get it right--the Lintner Model 1:11:27.020 --> 1:11:33.870 says that there's a target payout ratio--that's the Greek 1:11:33.871 --> 1:11:41.091 letter tau (τ) and that's the target payout ratio. 1:11:41.090 --> 1:11:45.920 That ratio may have been higher in the nineteenth century; 1:11:45.920 --> 1:11:48.790 it's gradually trending down, but it's a slow-moving thing. 1:11:48.789 --> 1:11:51.599 So they want to payout something like 40% of their 1:11:51.598 --> 1:11:54.918 earnings as dividends and plow the rest back into investing 1:11:54.921 --> 1:11:56.241 inside the company. 1:11:56.239 --> 1:12:01.489 Then there's another parameter, rho (ρ), 1:12:01.493 --> 1:12:08.063 which is the adjustment--rho is between zero and one. 1:12:08.060 --> 1:12:14.410 It's how fast they adjust to the target. 1:12:14.409 --> 1:12:23.689 So the Lintner Model then says, the change in dividends, 1:12:23.685 --> 1:12:30.935 Div_t - Div_T-1 = ρ 1:12:30.936 --> 1:12:39.196 (E_t - Div _T – 1). 1:12:39.199 --> 1:12:44.839 That means that if your rho is from a positive number like 1:12:44.837 --> 1:12:50.377 half--so if earnings is above dividends you increase your 1:12:50.375 --> 1:12:54.265 dividends, but only by half as much as 1:12:54.273 --> 1:12:59.023 would bring it up to the target, if rho is a half. 1:12:59.020 --> 1:13:05.940 That means there's a gradual adjustment of dividends to 1:13:05.940 --> 1:13:09.000 earnings. For example, 1:13:08.997 --> 1:13:16.957 if this is tau and this is earnings--if your earnings were, 1:13:16.959 --> 1:13:19.649 say, flat and suddenly increased 1:13:19.652 --> 1:13:23.312 like that, they wouldn't believe this increase at first, 1:13:23.310 --> 1:13:25.930 so the board would decide to adjust only, say, 1:13:25.933 --> 1:13:28.933 half way up. Now I'm plotting dividends. 1:13:28.930 --> 1:13:33.070 The dividends were down here at half the earnings and then you 1:13:33.073 --> 1:13:37.153 would gradually adjust them up to half the earnings again. 1:13:37.149 --> 1:13:40.549 That's because they don't want to ever be caught cutting their 1:13:40.550 --> 1:13:43.300 dividends. Also, if the earnings drop, 1:13:43.302 --> 1:13:47.932 they don't want to suddenly do a crash cut in their dividends 1:13:47.928 --> 1:13:50.418 either, so they're always sluggishly 1:13:50.416 --> 1:13:52.926 adjusting toward the target payout rate. 1:13:52.930 --> 1:13:57.950 Lintner showed that this simple model--the Lintner 1:13:57.946 --> 1:14:03.676 Model--explains the behavior of companies pretty well. 1:14:03.680 --> 1:14:12.350 Next session is Friday with Stephen Schwarzman and I'll see 1:14:12.354 --> 1:14:14.004 you then.