generate higher dividends in the future, so that the present value of
those dividends is unchanged, notwithstanding when they are paid.^10
The management can, of course, influence the time path of divi-
dends. The lower the dividend payout ratio, which is the ratio of cash div-
idends to earnings, the smaller the dividends will be in the near future.
But over time, dividends will rise and eventually exceed the path of div-
idends associated with a higher dividend payout ratio. Assuming the
firm earns the same return on investment as the investors require from
the equity, the present value of these dividend streams will be identical
no matter what payout ratio is chosen.
Although earnings drive the dividend policy of the firm, the price
of the stock is always equal to the present value of all future dividends
and not the present value of future earnings. Earnings not paid to in-
vestors can have value only if they are paid as dividends or other cash
disbursements at a later date. Valuing stock as the present discounted
value of future earnings is manifestly wrong and greatly overstates the
value of a firm.^11
John Burr Williams, one of the greatest investment analysts of the
early part of the last century and the author of the classic Theory of In-
vestment Value, argued this point persuasively in 1938:
Most people will object at once to the foregoing formula for valuing stocks
by saying that it should use the present worth of future earnings, not future
dividends. But should not earnings and dividends both give the same an-
swer under the implicit assumptions of our critics? If earnings not paid out
in dividends are all successfully reinvested at compound interest for the
benefit of the stockholder, as the critics imply, then these earnings should
produce dividends later; if not, then they are money lost. Earnings are only
a means to an end, and the means should not be mistaken for the end.^12A simple example should illustrate this proposition. Assume a
company’s stock is selling for $100 per share and earns 10 percent, or $10
per share each year, which, given its risk, is equal to the return investor’s
demand on its stock. If it paid all its earnings as dividends, it would pay
$10 per share every year into the future. This stream of dividends, if dis-
counted at 10 percent, yields a $100 share price.CHAPTER 7 Stocks: Sources and Measures of Market Value 101
(^10) Differential taxes between capital gains and dividends are an exception to this rule. If taxes are
higher on dividends, a high-dividend policy will reduce the value of shares.
(^11) Firms that pay no dividends, such as Warren Buffett’s Berkshire Hathaway, have value because
their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.
(^12) John Burr Williams, The Theory of Investment Value, Cambridge, Mass.: Harvard University Press,
1938, p. 30.