Dividend Policy Irrelevancy and the Construct of Earnings

Abstract

In a neo-classical setting of equity-valuation, this paper develops a principle of dividend policy irrelevancy (DPI) to identify and exploit characteristics of earnings. The latter refers to the idea that a value-relevant variable can not reasonably be labeled "earnings" unless it satisfies certain analytical properties with intuitive appeal. The paper proceeds in two parts. The first part, which culminates in Proposition I, provides necessary and sufficient conditions for DPI. The second part concerns how DPI predicates constructs of earnings and their analytical properties. A key result, Proposition II, shows that one can use the analytical properties of earnings to deduce the core approach in practical equity-valuation, namely, measures of growth in expected earnings explain the price to forward-earnings ratio. Abstract

Subdominant Eigenvalue Location and the Robustness of Dividend Policy Irrelevance

“…This formula was exploited in Ashton et al in [1], [2] in a stochastic setting. An identical formula can be developed for discrete time (with Laplace transform replaced by ztransform) and is the departure point for the purely algebraic argument developed in [7]. We note an important conclusion, which follows from the form of the adjugate matrix (or by invoking Cramer's Rule).…”

“…In [7] it is shown that dividend irrelevance at R occurs iff R takes the value of the dominant eigenvalue, here defined to be the largest in modulus (in the spirit of the Perron-Frobenius context -see [11,Ch. 8], [26,Ch.1,2]), of the reduced matrix A, which will forthwith be diagonal.…”

“…The principle of dividend policy irrelevancy also carries implications for the linear dynamics. For a recent analysis of the connections see [7], where the basic result asserts that DPI occurs iff the riskless interest rate agrees with the dominant eigenvalue of the reduced linear system ('subsystem') obtained by the firm withholding (retaining) dividend payouts. One may call the latter the dominant 'latent' rate of the system L. Recall that it is the riskless rate r that is used in the present-value calculation above.…”

“…A first problem is to determine circumstances under which the system exhibits dividend irrelevancy. Up to a technical side-condition (ensuring codependence of dividends and value creation) the short answer is that the dominant eigenvalue of A should agree with R -this was first proved by Ohlson in the special case n = 1, and then generalized in [7] (and also referred to in the earlier published monograph [23]). Below we refine the notion of dividend irrelevancy in order to study the effects of a proximal subdominant eigenvalue.…”

The Role of Assumptions in Ohlson Model Performance: Lessons for Improving Equity-Value Modeling

“…However, our conditional analysis showed that the fulfillment of the VDP did not affect at all the OVM performance as expected, since the VDP was not an assumption of the OVM. In this context, it is surprising to find more recent research that advocates the need to align the valuation models with the displacement property of dividends, such as that by Rees and Valentincic [45], Clubb [46], and Gao, Ohlson and Ostaszewski [47].…”