If instead the company did not pay a dividend but invested its
earnings in assets whose return is the identical 10 percent, the value of
the company would remain the same. Yet its earnings would grow to $11
per share in the second year, $12.10 in the third, and so on. The present
value of these per share earnings, discounted at a 10 percent rate of re-
turn, is infinite—clearly a nonsensical value for the firm. This is because
discounting earnings that are not paid out as dividends is wrong and
overstates the value of the firm. Under the assumptions given, the firm
is always worth $100, whether the firm reinvests the earnings at a 10 per-
cent rate of return or pays dividends to the shareholders.
The assumption that the firm earns the same rate of return on its re-
tained earnings as the market demands on its stock is a strong one, de-
spite the fact that it is often assumed in capital market theory to result
from optimal investment behavior of the firm. But the firm does not al-
ways invest optimally, as the previous section suggests. Frequently man-
agement engages in expenditures that have a lower return, and in that
case a policy of paying dividends will result in higher returns to share-
holders.
EARNINGS CONCEPTS
Despite the dependence of firm value on current and future dividends,
dividends are not possible on a sustained basis without positive earn-
ings. As a result, it is critical that a concept of earnings be developed that
gives investors the best possible measure of the sustainable cash that is
available for the payment of dividends.
Earnings, which are sometimes called net income, or profit, are sim-
ply the difference between revenues and costs. But the determination of
earnings is not just a cash-in-minus-cash-out calculation since many
costs and revenues, such as capital expenditures, depreciation, and con-
tracts for future delivery, extend over many years. Furthermore, some
expenses and revenues are one-time or “extraordinary” items, such as
capital gains and losses or major restructurings, and they do not add
meaningfully to the picture of the ongoing or sustainable earnings that
are so important in valuing a firm. Because of these issues, there is no
single “right” concept of earnings.
Earnings Reporting Methods
There are two principal ways that firms report their earnings. Net income
orreported earningsare those earnings sanctioned by the Financial Ac-
102 PART 2 Valuation, Style Investing, and Global Markets