No earnings, no price

“If you give me $1, I promise to give you 15¢”. The SMH can’t understand why people aren’t taking up this outstanding offer. I think I can …

The offer is for the purchase of ANZ shares with a guaranteed dividend that amounts to more than 15% of the price. Michael Pascoe of BusinessDay thinks that if we don’t take this up we’re saying we don’t believe that the banks are being run by competent people – and what’s more the share price has the possibility of capital growth!

This is a classic piece of dud thinking whose underlying assumption is that when all this nasty stuff blows over it’ll all be back to how it was pre-2007. But it almost certainly won’t do that.

Back to basics

Time to rehearse some really  basic stuff. Some people still believe that the stock market is about raising capital for business, but that hasn’t been true for many years: if you net off the IPOs with share buybacks, there has been no net new capital raised on most of the developed world’s stock markets since the 1970s. So, when you buy a share, you are simply buying an annuity – a future revenue stream of dividends – from someone else who thinks that it is overpriced (or they wouldn’t be selling).

If the stock markets were rational, the share price would be approximately equal to the net present value of all future dividends discounted at the cost of capital plus an estimate of the risk of those dividends not being paid. BTW, there is no evidence that stock markets have ever been rational (notwithstanding the never-ending financial page attempts to give rational explanations for what happens on them), but we’ll leave that for another day.

People also punt their belief that the stock price may rise, giving a capital gain at some future date – but in the long run this just amounts to a belief that the dividend stream will rise enough to justify that price rise, and that future gain should also be discounted into the NPV. Sellers meanwhile are in effect saying they believe that the prospect for dividends is lower than the market is currently pricing. An alternative way of looking at it is that sellers believe that there is a high risk that the dividend stream won’t be sustained, and hence discount the future payments at a higher discount rate.

Long-run basic part 2: dividends get paid out of earnings (unless the business is being run as a cash cow without reference to long-term viability – which the unkind might say is the Macquarie model). So, the deal is, we look at the dividend yield (dividend divided by share price), or, as a proxy for that, the price-earnings ratio (share price divided by profits).

What’s wrong with this picture?

So, is the share price for ANZ unbelievably cheap, with a promised 15.3% dividend yield? Well, only if you believe that the ANZ share price will still be at least as much as it is today after the dividend has been paid, so that after the dividend you can potentially sell it and get your initial dollars back.

However, if you happen to believe for some reason that there is a prospect that future earnings will be lower than last year’s, then you might believe that after the next payment future dividends will also be lower – and that therefore the share price once you’ve collected the dividend might be lower. If you think that the future earnings => dividends => share price might be as much as 8% lower, then that extraordinary, unmissable high yield gets reduced to the long-term average. If you, for some inexplicable reason, think that it’s possible that share prices might fall even more than 8% over the next month, then that guaranteed dividend isn’t high enough to support even the current price.

The rub

Other recent commentaries have similar speculations, which all boil down to a belief that the market has reached a bottom because the Div or P/E ratios have fallen to some particular benchmark. But the rub is: that’s assuming there are future earnings. In a recession, no-one can guarantee profitability, nor easily predict when profitability will return (or indeed whether the business will have the cash to survive losses for as long as it takes). No profits means no dividends means no bottom to the share price above 1¢.


In practice, no-one has a clue what the future dividend stream for individual shares is likely to be, and hence any share price, “high” or “low” is a punt. In these circumstances it is not at all surprising that share prices have been volatile: on one recent day, the Dow moved by 10% in a few hours (from 3% below the opening value to close more than 7% up). Unless you’re buying an index fund, you have to buy individual shares, and these have been even more volatile.

The unrefusable offer of 15¢ on the dollar suddenly looks all-too-possible to miss.

Disclosure: the Roffey family don’t own any shares at all except those vicariously owned through the UK pension schemes of PA Consulting Group and the London Borough of Haringey.