Morningstar Magazine - October/November 2017 - 49

EXHIBIT 1

on an ongoing basis, but only buys a new machine
every few years, has positive cash flows
in the short-run, but significantly negative cash
flows when the new machine is bought. In
accrual-based accounting, gains are recognized
when the product is sold, and ongoing expenses
are recognized by depreciating the machine
over time. By syncing when revenues and
expenses are realized over time, earnings provide
a clearer picture of contemporaneous gains
and losses of a business. Hence, its appeal as
a valuation measure.

Rise of Buybacks The gradual substitution of buybacks for dividends started in
the early 1980s.
1871-2016

Dividend Yield

Buyback Yield
15
%
12
9
6
2.38

3

2.10
Drawbacks of Earnings

Despite those benefits, there are several
drawbacks to earnings as a fundamental measure
of value. The discretionary nature of earnings is
perhaps the biggest. Generally accepted
accounting principles, or GAAP, the rules that
companies must follow when compiling financial
statements, provide corporate financial officers
with considerable leeway in estimating the
components that make up earnings. A recent study
by Dichev, Graham, Harvey, and Rajgopal
(2016), which surveyed close to 400 chief financial
officers, found that one in five companies
intentionally misrepresent earnings within the
discretion of GAAP.
Another drawback of earnings is the fact that the
accounting principles upon which they're
based tend to change over time, making it difficult
to compare today's earnings to definitions
of earnings of the past. A recent paper by Siegel
(2016) argues that the adoption of mark-tomarket accounting in the 1990s has structurally
depressed earnings, as companies have been
required to write-down assets, but cannot
write asset values back up. According to Siegel,
this asymmetry in asset write-downs versus
write-ups led to reporting earnings that
are structurally depressed versus history, raising
questions about earnings as a measure of
a firm's value that can be applied consistently
over time.
Investors 'Eat' Payouts, Not Earnings

In contrast to earnings, payouts are a cash flow,
representing the cash distributed to shareholders
via dividends and share buybacks (i.e., total
payouts). Because the value of a stock is

0
-3
1871

1890

1910

1930

1950

1970

1990

2010

Source: Morningstar.

the present value of its future cash flows (not
earnings), total payouts are closely linked to
a stock's intrinsic value. Because total payouts are
based on cash actually returned to shareholders,
they are generally easier to measure and not
subject to interpretation like accounting-based
measures. Total payouts are literally the cash flows
dispensed by the stock market and ultimately
consumed (or reinvested) by investors.
Also, in contrast to earnings, today's total
payouts are sensitive to a management's capital
allocation decision (i.e., distribution or retention of
cash flow). Higher retention (i.e., more investment)
today will decrease current total payouts, but
should boost payouts in the future. Thus, to assess
a firm's valuation, a long-term perspective is
necessary. It, therefore, makes sense to average
across 10 years of total payouts. Earnings,
meanwhile, due to the contemporaneous matching
of revenues and expenses described above, are
less prone to this asymmetry. In some sense, the
averaging of total payouts over multiple periods is
more important for CATY, because in addition to
smoothing out the cyclicality due to the business
cycle which is also relevant to earnings, averaging
total payout over 10 years helps smooth out
the lumpiness of cash flows due to managements'
payout policy. In the long run, however, as
highlighted by Miller and Modigliani (1961) in their
dividend policy irrelevance theorem, payout policy
does not matter. Lower (higher) payouts today

will lead to higher (lower) cash flows in the future
without an impact on the value of the firm.
Share Buybacks Surpass Dividends

Total payouts, the fundamental used in CATY,
includes both dividends and share buybacks.
The importance of the latter has grown
significantly in recent decades. The drastic change
in payout policy is highlighted in EXHIBIT 1 ,
which plots dividend and buyback yields since
1871. The figure shows that the gradual substitution
of buybacks for dividends started in the early
1980s. Buybacks surpassed dividends in eight
of the past 10 calendar years, supporting the claim
that buybacks have become an important way
for U.S. companies to return cash to shareholders.
Grullon and Michaely (2002) provide evidence that
the structural change in firms' payout policy,
among other factors, coincided with the adoption
of rule 10b-18 by the Securities and Exchange
Commission in 1982, which provided a safe harbor
for firms to conduct share buybacks without a
suspicion of share price manipulation.
shows the total yield of U.S. stocks from
1871 to 2016. The total yield series, which includes
both dividends and buybacks, appears to be
consistent over time, generally reverting around its
long-term mean. Boudoukh, Michaely, Richardson,
and Roberts (2007) examine the time-series
properties of dividend and total yields and find that
EXHIB IT 2

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