September 2018 - Finance Memos

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 FV^0.5

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

Are Tech Firms Overvalued

Question: The chart below has information on the trailing PE ratio, the forward PE ratio, the PEG ratio and 2014 and 2017 gross income figures for 9 tech firms.

How do the trailing and forward PE ratios differ for these 9 firms?

What is the implied growth rate in earnings from the trailing PE ratios and the PEG ratio? How do these implied earning growth rates compare to actual earing growth rates?

What is the implied growth rate in earnings based on the forward PE ratio and the PEG ratio? How do these implied earning growth rates compare to actual earing growth rates?

Financial Statistics for Nine Tech Firms
	Trailing PE	Forward PE	PEG	Gross Income December 2017	Gross Income December 2014
AAPL	20.35	16.56	1.46	88.2	70.5
AMZN	159.84	79.55	2.51	65.9	26.2
MSFT	52.8	22.91	2.07	72	60.5
FB	27.73	21.49	1.1	35.2	10.3
NFLX	169.65	85.72	2.19	4.03	1.75
GOOG	53.96	26.03	1.75	65.27	40.69
NVDA	40.83	35.11	2.17	5.82	2.6
EA	52.57	20.61	1.68	3.87	3.09
TXN	26.17	18.41	1.41	9.61	7.43

Analysis:

Below is information on the trailing and forward PE ratios for the 9 tech firms.

Comparing Trailing & Forward PE Ratios
	Trailing PE	Forward PE	Diff.
AAPL	20.35	16.56	3.79
AMZN	159.84	79.55	80.29
MSFT	52.8	22.91	29.89
FB	27.73	21.49	6.24
NFLX	169.65	85.72	83.93
GOOG	53.96	26.03	27.93
NVDA	40.83	35.11	5.72
EA	52.57	20.61	31.96
TXN	26.17	18.41	7.76
Average			30.83
Paired t test			0.018

The trailing PE ratio is larger than the forward PE ratio for all 9 firms.

This occurs because analysts are optimistic that forward earnings will exceed past earnings.

The paired t-test indicates we should reject the null hypothesis that the mean difference between the trailing and forward PE ratio is zero.

Note: The implied earnings growth forecast used in a PEG ratio can be obtained by dividing the PE ratio by the PEG ratio. The definition of a PEG Ratio is PE/G. This means PE/PEG or PE/(PE/G) is equal to G.

The actual annual growth rate of earnings between 2014 and 2017 is ((E17/E15)^(1/3)-1.

Below is the comparison of implied growth rates from reported trailing PE and PEG ratios to actual earnings growth rates.

Implied vs. Actual Growth Rates
	Trailing PE Ratio	PEG Ratio	Implied Growth Rate	Actual Average Annual Rate of Growth in Gross Profits 2014 to 2017
AAPL	20.35	1.46	13.9%	7.8%
AMZN	159.84	2.51	63.7%	36.0%
MSFT	52.8	2.07	25.5%	6.0%
FB	27.73	1.1	25.2%	50.6%
NFLX	169.65	2.19	77.5%	32.1%
GOOG	53.96	1.75	30.8%	17.1%
NVDA	40.83	2.17	18.8%	30.8%
EA	52.57	1.68	31.3%	7.8%
TXN	26.17	1.41	18.6%	9.0%

Implied growth rate based on trailing PE ratios.

For 8 of the 9 companies the implied growth rate from trailing PE ratio and reported PEG is larger than the actual growth rate in gross earnings.

Only NVDA had an implied growth rate lower than its actual growth rate.

Below is the comparison of the implied growth rates from reported forward PE ratios and PEG ratios to actual earnings growth rates

Implied vs Actual Growth Rates
	Forward PE	PEG	Implied Growth Rate	Actual Average Annual Rate of Growth in Gross Profits 2014 to 2017
AAPL	16.56	1.46	11.3%	7.8%
AMZN	79.55	2.51	31.7%	36.0%
MSFT	22.91	2.07	11.1%	6.0%
FB	21.49	1.1	19.5%	50.6%
NFLX	85.72	2.19	39.1%	32.1%
GOOG	26.03	1.75	14.9%	17.1%
NVDIA	35.11	2.17	16.2%	30.8%
EA	20.61	1.68	12.3%	7.8%
TSN	18.41	1.41	13.1%	9.0%

Implied Growth Rate based on forward PE ratios

For 5 of the 9 firms the implied growth rate based on forward PE ratio is larger than the actual growth rate.

The other 4 firms have higher actual growth rates than implied growth rates

Discussion:

Are these tech stocks overvalued?

My view is there is a lot of unjustified optimism about these stocks.

Many of these firms had high actual growth rates 2014 to 2017. This actual growth rate may be unsustainable.

Many of the implied growth rates calculated here are even higher than current unsustainable growth rates.

Perhaps analysts are using the growth rate of net taxes in their PEG estimates but tax cuts result in a one-time shift in earnings growth. Soon the tax cut will define net earnings in the bae year of the earnings growth calculation. This should decrease growth rates and cause the PEG ratio to rise.