Reconsidering Use of 401(k) Funds for Emergencies

Question:

Current tax rules governing 401(k) plans allow workers to distribute funds for hardship expenses prior to age 59 ½. The distributed funds are fully taxed at the ordinary income tax rate and subject to a 10 percent penalty.

Should rules governing 401(k) plans be changed to allow for the allocation of limited 401(k) funds to an emergency fund and new restrictions on the bulk of 401(k) contributions prior to age 59 ½?

In many states, people with assets in 401(k) plans and IRAs are not eligible for government benefits including food stamps.

Should these rules be altered so that funds not available for immediate disbursement do not impact eligibility for government benefits?

Specifics of the proposed rule changes are as follows:

  • Workers may allocate 20 percent of their 401(k) contribution or IRA contribution to an emergency fund.
  • Funds placed in the emergency fund could be distributed for emergency expenses without being subjected to income tax or a tax penalty.
  • Disbursements from all 401(k) or IRA contributions not in the emergency fund prior to the age of 59 ½ would be prohibited.
  • Future 401(k) loans would be eliminated.
  • Funds in 401(k) plans and IRAS that were not available for immediate disbursement would not be counted toward Medicaid or food stamp eligibility.

Background:  Many workers, especially those entering the workforce, must choose between establishing an emergency fund or saving for retirement through a 401(k) plan.   The financial advantages associated with 401(k) plans, both in the form of an employer match and tax savings can be substantial.   However, many workers have insufficient funds to pay rent, health bills and outstanding loans.  Some workers with limited liquidity choose to create a retirement fund and delay saving for retirement.

The IRS allows workers to withdraw money from their 401(k) plan prior to retirement but the practice is discouraged through the imposition of a 10 percent penalty.

Around 87 percent of 401(k) plans allow workers to borrow funds form their 401(k) plan.  Around 18 percent of workers in plans allowing 401(k) loans had loans outstanding.   The average outstanding loan balance for 401(k) loans at the end of 2015 was a bit lower than $8,000.

Go to the ICI web site for some information on 401(k) plans.

https://www.ici.org/policy/retirement/plan/401k/faqs_401k

Workers with 401(k) plans who leave their current position must either repay their loan or be subject to additional tax and a financial penalty.

In many states, people with 401(k) plans are not eligible for food stamps or Medicaid.

https://www.brookings.edu/wp-content/uploads/2016/07/03_increasing_saving.pdf

 

https://www.agingcare.com/articles/how-401k-accounts-and-iras-affect-medicaid-eligibility-208382.htm

These rules discourage low-income workers with variable income from making 401(k) contributions.

Discussion

Contributions to 401(k) plans, unlike contributions to traditional pensions or Social Security, are voluntary.  Some people with limited liquid assets and high debt levels are reluctant to tie up funds in a retirement account.   The early disbursement option (albeit with taxes and penalty) and the loan option can encourage some people to contribute to their 401(k) plan.

Individuals who disburse funds from 401(k) plans prior to age 59 ½ may have insufficient resources in retirement.  Moreover, individuals who take disbursements prior to age 59 ½ and pay taxes and a penalty may become worse off than individuals who never contributed to their 401(k) plan.

 The emergency fund feature of the new 401(k) would provide substantial incentives for people with limited liquidity and large debts to make 401(k) contributions.   However, the prohibition against early disbursements from the bulk of 401(k) contributions could reduce the number of people with insufficient funds in retirement.

 Under the new rules, 401(k) or IRA funds not available for immediate disbursement would not affect eligibility for any government benefits.   This change would encourage low-income people to make additional contributions to 401(K) plans and IRAs.

 

 

 

 

 

The Politics of Student Debt

In a recent episode of Madam Secretary, the daughter of the Secretary quits her volunteer position on a Congressional campaign because her candidate did not have a bullet point on forgiving student debt.   The candidate explains to her that debt forgiveness is too controversial because it takes money from workers and taxpayers and give money to students.  The Secretary lectures the daughter and persuades her to vote despite her problems with this candidate on this one issue.

This episode relives one of the flash points of the 2016 Clinton/Sanders contest.   Bernie Sanders supported an expensive and unrealistic free college program. This idea was first scorned and then matched by Clinton.  Clinton continued to struggle with the issue by coming up with ideas like let’s forgive debt for employees at start-up firms an idea that was laughed at by virtually everyone who has studied the student debt problem.

Student debt is a growing problem much larger for the current cohort than for previous generations.

  • The percent of graduate with student debt went from 50 in 1989/1990 to near 70 today.
  • The percent of borrowers leaving school with more than $50,000 in debt went from 2 percent to 17 percent over same period.
  • The number of Americans over age 65 with student debt increased by a factor of 4 between 2005 and 2015.

High student debt levels have long term financial consequences.  People with high student debt levels often either delay savings for retirement or delay loan repayments.   Often student debtors also delay marriage, forego having children and choose to rent rather than purchase a home.

Trump Administration proposals will worsen student debt problems.  The Trump Administration is proposing to eliminate subsidized student loans, a change that will increase debt costs and cause many to forego college.  The Trump Administration has rejected loan forgiveness applications under the public service loan programs and their actions will weaken the Income Based Replacement loan program.   The Trump team does not support of enforce rules protecting students from fraud.

Student debt like health care should be a big wining issue for Democrats.  Unfortunately, Democrats are divided between keeping the status quo and giving free college to everyone.

Doing nothing should not be an option.  Part of the solution involves increased financial assistance to students, especially for first-year students.

Many students leave college after their first year because of academic performance.  Problems associated with first year students who fail to continue their education could be substantially reduced in a cost-effective way by expanding assistance to first-year students.

Part of the solution involves policies and programs which improve on-time and early graduation rates.

Many students either fail to graduate or take more than the allotted time to complete their program.  These students tend to take on more debt and are more likely to incur payment problems.

Realistically, improvements in and expansion of debt forgiveness programs must be part of the solution because many borrowers become hopelessly overextended.  Some Democrats are currently focused on expanding the Income Based Replacement loan program.   Loan servicers regularly ignore the IBR options and debt forgiveness programs centered on the IBR program are likely to fail.

There are other more cost-effective ways to assist overextended borrowers.

Granting priority to student debt over consumer loans in Chapter 13 bankruptcy:     Currently, many applicants for Chapter 13 bankruptcy reduce student loan payments to repay credit cards and other consumer loans.  Often the student borrower leaves bankruptcy with an increased student debt balance.  The quicker repayment of student loans in bankruptcy benefits both taxpayers and student debtors.

The elimination of the link between market interest rates and interest rates on federally guaranteed student loans.   Under current rules student debt interest rates are tied to market interest rates.   This policy automatically increases costs for an entire cohort should Treasury rates rise.  This is a timely problem given recent Fed statements and moves.

Modification of the standard contract on student loans to allow for interest-only payments rather than forbearances and to allow for reduction or even elimination of interest rates after 15 years of payments:   The IBR program allows some people to borrow more without increasing the amount they repay.  By contrast, under the proposed interest elimination plan, people who borrow more repay more.  This program has better incentives and is less expensive to the taxpayer than the IBR program.

Restricting parental guarantee obligations on PLUS loans and cosigned private student loans to 5 years from repayment date:   Many of the most severe financial problems associated with student debt involve PLUS loans guaranteed by parents.   This change would reduce these problems.

 Removal of the prohibition against the discharge of high-interest private student loans in bankruptcy: This proposal returns us to rules that existed prior to the enactment of the 2004 bankruptcy law.   The discharge of private student debt in bankruptcy could accelerate payment on government guaranteed debt and assist taxpayers.

Creation of a modified public service loan program, which will allow for partial loan forgiveness after 2 to 5 years rather than 10 years of public service:   The current program creates job lock by forcing applicants to wait at least 10 years for loan forgiveness.  The shorter period for partial loan relief for the new program reduces job lock.  This program will be less expensive and have lower administrative costs than the current program.

Issues like student debt and health insurance are core issues to Democratic voters, which should drive voters to the polls.  However, there are huge differences in the way the Sanders wing and the Clinton wing approach the problem.   The Sanders proposals would cause either a fiscal crisis or unsustainable tax increases combined with stagnation.   The Clinton wing is proposing a band aid for the sake of appearances.

I understand why the screen writers of the show on Madam Secretary are frustrated at the Sander’s supporters who chose to stay home in 2016 rather than vote for an imperfect candidate who is a thousand times better than Trump.   However, Democratic candidates must have a comprehensive vision and set of policies on student debt.   College costs and debt are an existential problem for current students and recent grads.   The cost of college will deter many from getting necessary education.   The debt incurred will have long term often crippling impacts on household finances and even happiness.

There are common sense centrist solutions to this problem that increase access to education, reduce costs for overextended students and are fair to workers and taxpayers.

The failure of the Democrats to address student debt issues is sort of like a football team deciding to punt on first down.  This is not an effective way to either win the game or excite your fan base.

 

Authors Note:

David Bernstein is the author of Innovative Solutions to the College Debt Problem.   Get his book on Amazon or on Kindle.

 

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

David has also written on health care and the ACA.

 

Go here for a Centrist Health Plan:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3263159

 

 

I would love to work for a centrist Democrat in 2020.  Contact me at Bernstein.book1958@gmail.com or on my cell 202 413 5492.

 

 

Unemployment, Labor Force Participation, and the Government Deficit

Unemployment, Labor Force Participation and the Government Deficit

Issue:   The Chart below has data on three important economic variables – the unemployment rate, the labor force participation rate and the government deficit as a percent of GDP.   The unemployment and labor force participation rate variables are observed on three dates   — July 2009 (near the peak of the recession) January 2017 (the month of President Trump’s inauguration), and September 2009 (the most recent month at the time of this writing.

What does this data say about the recovery after the recession under President Obama?

What does this data say about the impact of President Trump’s economic policies on the labor market and on the government deficit?

How does information from the unemployment rate and information obtained the labor force participation rate differ regarding, evaluations of the economic records for Obama and Trump, an assessment of the current strength of the economy and projections of the likely path of debt to GDP?

Three Economic Variables
Unemployment Rate
Date Value
Jul-09 9.5
Jan-17 4.8
Sep-18 3.7
Labor Force Part. Rate
Jul-09 65.5
Jan-17 62.9
Sep-18 62.7
Government Deficit as % GDP
Date Value
FY 2009 -9.8
FY 2016 -3.2
FY2018 -4.2

Trends:

The unemployment rate fell from 9.5 percent during the recession to 4.8 percent at the end of President Obama’s term.

The unemployment rate has continued to fall under President Trump and is currently at 3.7%.   This is the lowest level since 1969.

The labor force participation rate was higher during the recession than at the end of President Obama’s term.

The labor force participation rate has not risen under President Trump despite the tax cut.

 

The government deficit fell from 9.8 percent of GDP in 2009 (recession year) to 3.2 percent in 2016 (last Obama year.)

The FY 2018 deficit as a percent of GDP is 4.2 percent, substantially higher than when President Obama left office.

Discussion:

An analysis of economic conditions and the labor market based on the unemployment rate alone would conclude that the job market and economy are red hot.   The unemployment rate has not been this low since 1969.  President Trump’s tax cut is one reason why the unemployment rate fell to its current level.

An analysis of the recovery from the recession and current economic condition incorporating information about the labor force participation rate, indicates the economy is not over heated.

Many critics of President Obama claimed that recovery was weak because the labor force participation rate remained very low.

https://freebeacon.com/issues/obama-economy-9-9-million-employed-14-6-million-left-labor-force/

The labor force participation rate is lower under President Trump than under President Obama.   President Trump’s economic policies have failed to increase the labor force participation rate.

President Trump’s economic policies have increased the government deficit as a percent of GDP.  The 2018 fiscal deficit is over 30 percent higher than the 2016 fiscal deficit.

Concluding Thoughts:

My view is that the LFPR has decreased due to population aging and further stimulus will not expand the workforce.  Moreover, the decrease in unemployment which coincided with the tax cut will not persist for much longer.   The loss of revenues from the tax cut will be larger in FY 2019, 2020 and 2021.   The budget deficit could be larger than 9 percent of GDP prior to the start of the next recession.

President Trump by reducing taxes and expanding deficits in a strong economy has weakened the ability of fiscal authorities to stimulate the economy when the next recession hits.

Authors Note:   I hope you will try my book

Innovative Solutions to the College Debt Problem:

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

 

 

 

 

 

 

 

 

A Red Tide and a Blue Wall 

There is a lot of discussion, hope and prayer for a blue wave leading to the Democrats retaking the house.  The House is very hard to predict.    Now I am focused on two other aspects of the election – a Red tide controlling outcome of the Senate and the rebuilding of the blue wall.

The Red Tide:

A red tide occurs when algal blooms become so numerous the coast gets discolored and water becomes unpleasant to swim in.   The Republicans by suppressing the vote in numerous states and by colluding with the Russians have created the political equivalent of the red tide.

Political pundits are claiming many Senate sears are in play.   Mitch McConnell lists 9 senate seats that are dead even.

I list 5 seats (AZ, FL, IN, NV, and MO) that are dead even.  Polls are going back and forth in these states.  I am concerned that FL could flip if the voting irregularities that helped Governor Scott in 2014 reoccur.

https://www.local10.com/news/elections/judge-rejects-emergency-motion-by-crist-camp-to-extend-broward-county-voting-hours

Two seats (MT and ND) are not even but are in play.  The polls are close but consistently favor the Democrat in MT.   Poll averages are deceptive in ND as proven when Heitkamp fueled by a large Native American vote pulled out a surprise victory in 2012.  Also, the RCP average in ND was affected by two large outliers.

This time many Native Americans will not be able to vote.

https://www.npr.org/2018/10/13/657125819/many-native-ids-wont-be-accepted-at-north-dakota-polling-places

Republicans in red states are getting very good at voter suppression.    Have you read about the exact match program in Georgia?

Exact Match in Georgia

https://www.nbcnews.com/politics/politics-news/georgia-sued-placing-thousands-voter-registrations-hold-election-n919526

The pundits believe that TN and TX are in play.    My view is that Republicans are highly likely to hold both states.

  • Breedsen cratered when he stated that he would support Kavenaugh. Volunteers quit.  Last three polls were abysmal.
  • TX is highly polled. Polls are relatively close but Cruz leads in just about every poll.

There have been some accusations about voter suppression in Texas but some articles say this problem is being fixed.  We’ll have to see.

 

Voting in Texas:

https://www.startelegram.com/news/state/texas/article219921185.html

 

Senate control depends on these races but objectively the Republicans have many more paths than the Democrats.

This is supposed to be the year of the woman. but sadly two senior female Democrats Macaskill in MO and Heitkamp in ND are in dogfights.   The number of female democrats could fall depending on these outcomes and results in AZ and NV.

Restoring the Blue Wall: 

There is some good news for the Democrats.   The blue wall in Michigan, Wisconsin and Pennsylvania is being repaired.  The Democratic incumbent running for reelection is up by double digits in all three states.

All three states which were blue for decades, went for Trump over Clinton in 2016.

Many of the people in these states appear to regret their vote for Trump.

Even more surprising is that Democratic Gubernatorial candidates are leading in the polls in Ohio and Iowa against two strong GOP candidates.  Obama won both states twice but Trump won both states by large margins.

It does appear as though some voters want to send Trump and the GOP a message

The ability of the GOP to stop Democrats from voting may be too much for the Senate contest.

 

Some RCP Data:

 

Senate Race RCP Averages
State RCP Average Red – Blue
AZ 0.3
FL -2.4
IN -2.5
MO 0.4
NV 0
MT -3
ND 8.7
WV 9.4
TN 5.5
TX 7
OH -16
WI -10.6
PA -16

 

 

 

 

 

Discussion of a Centrist Health Care Plan

The Republican and Progressive views on the future of health care are clear.   Republicans want to repeal the ACA and move us towards a system with fewer regulations.   The Trump Administration has taken us towards this goal by ending the individual mandate, ending reinsurance subsidies, and legalizing bare-bones health plans.

The Progressives want either a single-payer system or a Medicare-for-all option.   Republicans are attacking Democrats for their support of the single-payer option.   Some of these attacks may stick because centrist Democrats have not put forward a clear centrist plan that improves health insurance and health care.

A Centrist Health Care Plan is the topic and name of my new paper, available at SSRN

A Centrist Health Plan:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3263159

The proposals discussed here include – (1) new incentives to encourage continuous health insurance coverage, (2) alterations to rules governing health savings accounts and high deductible health plans, (3) rule changes leading to reduced reliance on employer-based insurance, and (4) government subsidies for certain expensive health care cases, which are not easily treated by narrow-network HMOs.

The ACA was a good first step towards expanding and improving health insurance coverage.  Republicans failed to totally repeal the ACA but under Trump the nation is moving backwards.   The individual mandate and reinsurance subsidies have been eliminated and new bare-bone insurance policies undermine comprehensive insurance.

The individual mandate as previously structured was unpopular.   It could be replaced with a tax credit exclusively for people with comprehensive health insurance.

The new temporary bare-bone insurance plans can be eliminated by executive order.

Many health care problems were not affected by the ACA.   The trend towards higher deductibles and larger out-of-pocket expenses was accelerated by the introduction of health savings accounts coupled with high-deductible health plans.    Many Americans now actively debate whether they should reduce contributions to 401(k) plans to maintain contributions to health savings accounts.  Other Americans actively consider foregoing needed prescription drug regimens so they will have funds for their retirement.

Financial instability and health problems caused by the increased use of health savings accounts coupled with high-deductible health plans can be reduced by a new tax credit and by more flexible rules governing contributions to health savings accounts.

Issues caused by narrow-network health plans, which do not allow access to top doctors and hospitals predate the ACA.  Narrow-network health plans provide great health care for the vast majority of health care conditions.   However, access to certain specialists for certain diseases like cancer is often limited.   This issue can be called the breaking bad problem after the fictional chemistry teacher who manufactures and sells meth to fund his cancer treatment.

The Republicans maintain reinsurance or risk-adjustment payments are subsidies to insurance companies, a form of corporate welfare that must be eliminated. Under the Centrist proposal, the government subsidy for expensive health care procedures would be sent directly to the out-of-network provider on behalf of the patient.  These subsidies would allow the narrow-network health plan to contract out complex procedures, concentrate on basic health care problems and maintain low premiums.

The ACA attempted to create a viable individual health insurance market by changing rules governing coverage for pre-existing conditions and underwriting of health insurance premiums.   However, ACA rules still substantially favor employer-based health insurance over the new state exchange market places.   A centrist Health plan would cautiously reconsider these rules to strengthen the nascent state exchange market places.

The new subsidies for contributions to health savings accounts and expensive health care cases are partially paid for by reductions in tax expenditures on ACA and employer-based insurance.

 

 

 

 

The Issue is Garland Not Kavenaugh

The Issue is Garland Not Kavenaugh

I tend to believe the accusations of sexual assault made by women including both the accusations made against Kavenaugh and Ellison.   The Democrats are a bit hypocritical to attack Kavenaugh and give Ellison a pass.

I would vote against Kavenaugh  even without the assault allegations.  I would vote against Kavenaugh because he was not fully vetted and because of what the Republicans did to Merrick Garland.

In 1991 near the end of the Bush presidency Clarence Thomas replaced Thurgood Marshall.  Even with the Anita Hill controversy   Thomas got a vote.  Merrick Garland was a fairly conservative pick for a Democrat.  He is also squeaky clean. He did not get a vote.

The failure to seat Garland may give Republicans control of the court for a very long time.

We cannot have one set of rules for approving Republican judges and anothe set of rules for approving Democratic judges.

The Democrats will take power back some day.   When they regain power, they must do whatever is necessary to restore the balance of the court.  Critics of this approach will rant that two wrongs don’t make a right.   The correct answer is based on the theory of second best.

Regular order where valid nominees get a hearing and are fully vetted is the first best solution.  The first best solution does not exist. Republicans created a situation where Democratic nominees don’t get heard and Republican nominees don’t have to be fully vetted.

Democrats once they return to power must restore balance to the court. One way for the Democrats to fix the situation once they return to power is to totally restructure the court.   A less drastic fix would be to indict or impeach Kavenaugh over the multiple allegations of perjury.

Republicans are very confident that in the short term they will prevail.  They may be right.  This topic will be explained in the next post.

Please subscribe to this blog and consider my book on student debt.

https://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446

 

 

Do Dividends Affect Firm Value?

The Impact of Dividend on Stock Prices — a Regression Analysis

 Question:   Do firms that pay dividends have a higher stock price than firms that don’t pay dividend after accounting for earnings per share and sales per share?

Motivation:   The issue of whether dividends impact the value of the firm is a central discussion for students of finance. (My Ph.D. dissertation was on this topic.)

Modigliani and Miller found that if capital markets are perfect dividend policy will not impact the value of the firm.  More recent work indicates that dividends can influence firm value when capital markets are imperfect and insiders have better information than outsiders.

Dividend payments are unlikely to increase share value for older firms or firms with fewer growth opportunities.  By contrast, high fliers like Amazon and Netflix do not pay dividends.

Dividends can be associated with either higher or lower share prices.   The results can differ across industries and across samples of firms.

The Data:   The analysis is based on a single cross section of 67 firms.  The data was collected in mid-September 2018 after the close of market on a weekend.  Roughly half of the firms are large-cap growth firms and the other half are large cap value firms.

The data used in the regression analysis is described in the table below.

Description of Data in Regression Model
Mean Std. Err.
earnings per share 6.43 1.04
sales per share 160.29 91.41
Positive dividend dummy 0.87 0.04
price of a share 196.51 41.51

 

The Regression Results:

 

 

Regression Results for Share Price Equation
  Coeff. t-stat
Earnings Per Share 10.5 2.36
Sales Per Share 0.2 3.63
Dividend Dummy -331.0 -4.27
_cons 385.6 4.92
R2 0.66
N 67.0

 

Discussion of Regression Results

All three variables – earnings, sales and dividend dummy – are significantly related to price per share.

The dividend coefficient is negative suggesting that dividend payments are associated with lower share prices.

Why are dividend payments reducing share value in this sample?

The sample includes some growth names – Facebook, Amazon, Google, Netflix – which do not pay dividends.   The sample also includes some more established firms – GE, IBM, Coke, Pepsi and Bank of America – which are not growing fast but do pay dividends.

In this sample, growth prospects appear to have a larger impact on stock price than the promise of dividends.

Traditionally, firm earnings has been considered the more important determinant of stock price.  However, the sales coefficient has a larger t-statistic than the earnings coefficient.

Caveats: 

The model is built with cross-sectional data.  Cross-sectional models often do not explain the change in stock prices over time.

The dividend variable could be an endogenous variable.  A second equation that predicts dividend behavior and the level of dividends could be added.

A larger model might include information on capital expenditures and share buybacks.

 

 

 

Are Dividend Payments Sustainable?

 

Contingency Tables of Dividend Yields vs Dividend Payout

Issue:  Contingency table of dividend yield versus dividend payout for 35 growth stocks and 35 value stocks are used to analyze the sustainability of dividend payouts.

Contingency tables for the two portfolios are presented below.

 

Contingency Table for Dividend Yields vs Payout Ratios –

 Growth Firms

Dividend Yield
Dividend Payout 0 >0  & <=2 >2 & <4 >=4 Total
0 9 0 0 0 9
<=50 0 13 1 0 14
>50 & <=90 0 2 5 0 7
>90 or <0 0 0 4 1 5
Total 9 15 10 1

35

 

Contingency Table for Dividend Yields vs Payouts –

Value Firms

Dividend Payout 0 >0  & <=2 >2 & <4 >=4 Total
0 1 0 0 0 1
<=50 0 5 5 2 12
>50 & <=90 0 2 5 0 7
>90 or <0 0 3 10 2 15
Total 1 10 20 4 35

Comments on the Construction of the Contingency Tables:

The columns of the table are based on the dividend yield defined as annual dividend payments as a percent of the current stock price. The dividend yield measures the generosity of a firm’s dividend.

The dividend yield categories are – yield = 0, yield > 0 &yield <2, yield >=2 and yield <4, and yield >=4.

The rows of the table are based on the dividend payout ratio defined as dividend as a percent of income.   The dividend payout ratio measures the ability of a firm to maintain dividends in the future.

A dividend paying firm with negative earnings (or an undefined dividend payout ratio) is not likely to be able to continue paying dividends.

The four dividend payout ratios considered here are payout =0, payout<=50, payout>50 & payout<=90 and payout >90 or payout<0.

Note I have placed firms with negative earning that are currently paying dividends and firms with dividend payout ratios greater than 90 in the same high dividend payout category.   This makes sense because firms with high dividend payout ratios and firms paying dividends even though they have negative earnings will have trouble sustaining dividend payments unless earnings grow.

Note also by definition of yield and payout all firms with dividend yield equal to 0 also have dividend payout equal to 0.

Observations about dividend payments and sustainability of payments for growth and value firms:

 Growth firms pay less in terms of dividends than value firms.   There are 9 of 35 growth firms with a 0% yield compared to 1 of 35 value firm that pays no dividends.

A substantial percent of value firms may not be able to sustain their current dividend level.   15 value firms have a dividend payout over 90 or under 0 compared to only 5 of 35 growth firms.

Concluding Remarks:    The tech sector and growth ETFs have led the market upwards over the past couple of years.   A lot of analysts believe that the market can continue upwards through a rotation to value stocks.

I don’t see this happening.   Over 40 percent of my sample of dividend paying value firms has a payout ratio over 90 or negative earnings.   Their current dividend yield while attractive may not be sustainable.

A previous analysis of PE ratios indicated that many analysts are understating the overvaluation of value firms by ignoring firms with undefined PE ratios.

https://financememos.com/2018/09/12/valuation-of-growth-and-value-stocks-with-pe-ratios/

 

Valuation of Growth and Value Stocks with PE Ratios

Question:   The chart below contains the frequency distribution for trailing and forward PE ratios for 33 growth firms and 31 value firms.  The data was collected from the top 35 positions from two ETFs – VUG Vanguard large cap growth and VTV Vanguard large cap Value funds. Two growth stocks and four value stocks were omitted from the analysis because of negative earnings, which leads to an undefined PE ratio.

What can we learn about the relative valuations of growth and value firms from this chart?  How did the omission of firms with negative earnings impact our conclusions?  How do conclusions based on trailing PE and forward PE ratios differ?  What are the economic implications of large differences between trailing and forward PE ratios?

The Data:

Trailing PE Ratios
Growth Stocks Value Stocks
Freq. Percent Freq. Percent
Under 15 5 15.15 6 19.35
15 to 25 10 30.3 11 35.48
Over 25 18 54.55 14 45.16
Total 33 100 31 100
<=75 28 84.85 25 80.65
>75 5 15.15 6 19.35
Total 33 100 31 100
Forward PE Ratios
Freq. Percent Freq. Percent
Growth Stocks Value Stocks
Under 15 5 15.15 25 80.65
15 to 25 19 57.58 6 19.35
Over 25 9 27.27 0 0
Total 33 100 31 100
<=75 31 93.94 31 100
>75 2 6.06 0 0
Total 33 100 31 100

Short Answer:  Analysts on television routinely discuss PE ratios when talking about the valuation of the market.   Their analysis does not specify how PE ratios are assigned to firms with negative earnings or whether these firms are omitted from the sample.   The analyst often fails to state whether his analysis is based on trailing or forward PE ratios. Many analysts routinely present statistics, which understate the extent stocks are overvalued.

Observations about Growth and Value Firm PE Ratios

54 percent of growth firms and 45 percent of value firms report a trailing PE ratio greater than 25.

27 percent of growth firms and 0 percent of value firms report a forward PE ratio greater than 25.

15 percent of growth firms and 19 percent of value firms report a PE ratio greater than 75.

6 percent of value firms and 0 percent of growth firms report a forward PE ratio greater than 75.

Discussion of Growth and Value PE Ratios

I have not reported mean PE ratios because of outliers.  The max PE ratio for value firms in our sample was 272 for growth firms and 2352 for value firms.

The exclusion of firms with negative PE ratios makes it very difficult to measure and compare valuations.   Many analysts top-code firms with large or negative PE ratios.  One way to deal with this issue is to look at the earnings to price ratio (the reciprocal of the PE ratio) or to use techniques mentioned in a previous blog.

https://financememos.com/2017/10/11/two-ways-to-calculate-a-portfolio-pe-ratio/

This analysis substantially understates the current overvaluation of value firms.  Why do I say that?

  • First, more value firms than growth firms have negative earnings and have been excluded from the sample. The excluded negative earnings firms are arguably more overvalued than firms with low positive earnings and a high PE ratio.
  • Second, as noted the PE outlier is larger for the large cap value sector than the large cap growth firms.

A valuation analysis based on PE ratios does not always result in a larger bias for value firms than growth firm.   A comparison of small cap growth to small cap value firms might find more growth firms with negative or astronomic PE ratios than presented here for the comparison of the two large-cap portfolios.

The lower forward portfolio PE ratios are the consequence of an optimistic assumption on earnings growth.   As shown in a previous post one estimate of projected earnings growth is 100*(PET/PEF)-1 where PET is trailing PE and PEF is forward PE.

http://www.dailymathproblem.com/2018/09/financial-ratio-math.html

Projected Growth Rate in Earnings from the Comparison of

Trailing and Forward PE Ratios

Growth Stocks Value Stocks
Min -45.1 -51.6
Max 1,615.9 16,146.5

The comparison of trailing and forward PE ratios implies substantial dispersion in projected earnings growth.

It is very easy for an optimistic analyst or an analyst who wants to sell stock to juice forward earnings and make valuations seem more reasonable than they are.

Concluding Remark:

PE ratios are often imprecise measures of firm valuation, especially when earnings are low.   Analysts are using forward earnings estimate to obtain a more optimistic picture of the overall market valuation.  But are these estimates valid or reasonable?

 

 

 

 

The Elimination of Subsidized Student Loans

The Trump Administration is proposing the elimination of subsidized student loans.  This post provides estimates of the additional costs of this proposal based on the number of years students stay in school.

Introduction:   Currently, low-income undergraduate students can take out a total of $31,000 in federal student loan.  Subsidized student loans are only available to people in low-income households.  The main difference between subsidized and unsubsidized student debt is that the government pays all interest costs on subsidized debt when the student is in school while interest accrues on unsubsidized loans.

The current limit on subsidized student loans is $23,000.  The total limit on undergraduate federal student loans is $31,000.

The Trump Administration is proposing to eliminate all subsidized student loans.

The purpose of this post is to model and analyze the  impact of this policy change for a student who is planning to take full advantage of subsidized student loans.  I also examine how this financial cost depends on the number of years it takes for the student to graduate.

Methodology:   I set up a spread sheet where the key model inputs are number of years it takes for a student to graduate, the interest rate on the student loan, and the maturity of the student loan.

Key Assumptions:

In this model, I assume the student borrows $31,000/n each year where n is the number of years it takes for the student to graduate.  When subsidized loans exist the annual total borrowed for subsidized loans is $23,000/n and total unsubsidized loans for the course of the person’s undergraduate career is $8,000.

(An expanded version of this model will consider uneven borrowing scenarios, where student borrows a different amount each year or perhaps drops out from school for a few years.)

Student remain in deferment until six month after graduation or leaving school.

Student does not apply for loan deferments for economic hardships or when unemployed.

The interest rate is 5 percent.

Student loan maturity is 20 years.

The procedure to calculate lifetime costs involves two steps.

Step One: Calculate the total loan balance on the day the student borrower starts repayment.  The subsidized loan at time of repayment is equal to the balance when issued since all interest is paid for. The FV of the unsubsidized loan is determined at time of graduation and multiplied by (1+0.05)0.5 to account for the six-month delay in repayment after graduation.

Inputs of FV function:

INT interest rate 0.05 or some other assumption.

NPER number of periods in this case number of years in school.

PMT is payment in this case the annual loan amount.

PV in this case 0

Type is ! for end of period.

The FV gives the value of the loan at graduation.   Repayment is six months later.   The value of the loan at repayment is FV0.5

The total loan balance is the sum of the subsidized and unsubsidized loan balance at time of repayment.

Step Two:  Calculate total payments over the lifetime of the loan.  This is done by using PMT function to get monthly payment and then multiplying by the total number of payments.

Spreadsheet for person who graduates in four years:

row Subsidized Loans No Subsidized Loans
2 Date of First Loan Payment 9/1/10 9/1/10
3 Subsidized Loan $23,000 $0
4 Unsubsidized Loans $8,000 $31,000
5 Interest Rate 0.05 0.05
6 Number of years In school 4 4
7 Date Repayment Starts 3/2/15 3/2/15
8 FV of subsidized loans $23,000 $0
9 FV of unsubsidized Loans $9,275 $35,940
10 Total Loans $32,275 $35,940
11 Loan Maturity 20 20
12 Loan PMT -$213 -$237
13 Lifetime Payments -$51,120 -$56,925
  • The elimination of subsidized loans increases lifetime repayment costs of the loan by $5,805 when the person graduates in four years and starts repayment six months after graduation.  (The other key assumptions are a 5% student loan interest rate and a 20-year student loan.)

Impact of delays in finishing schools:

The addition cost stemming from the loss of the subsidy can be obtained by changing line 6 of the spreadsheet number of years in school.   Below we present results for # of years in school for 4, 5, and 6.

Calculations are below:

# of Years in School Payments with Subsidized Loans Payments with No Subsidies Difference
4 $51,119.83 $56,924.81 $5,805
5 $51,496.04 $58,382.62 $6,887
5 $51,884.94 $59,889.61 $8,005
  • The elimination of subsidized loans leads to even higher costs for the person who spends more years in school.   Additional lifetime costs of loans are $6,887 for the person who graduates after 5 years and $8,005 for the person who graduates after six years.

Authors Note:  My student debt book looks at existing student debt and financial aid programs and proposals offered by both the Trump Administration and candidates in the Democratic party.   I then offer my own solutions to the problem.

The book is available on Kindle.

Innovative Solutions to the College Debt Problemhttps://www.amazon.com/Innovative-Solutions-College-Debt-Problem/dp/1982999446