Blackwell Reference Online

Extract

Earnings and dividends can both provide useful information in equity valuation. Theory tells us that equity value is equal to the present value of expected dividends. Equivalently, equity value can be expressed as a function of the current book value of equity and the present value of expected abnormal earnings. The latter formulation offers arguably the more powerful perspective, because it links equity value more directly with accounting measurement. Financial position and performance are measured, albeit imperfectly, by net asset value in the balance sheet, earnings in the income statement, and by the return on capital (the ratio of earnings to net asset value). These measures provide a basis for understanding how effectively a company has employed shareholders' funds in the past, thereby giving a foundation for understanding how well they might be used in the future and, thereby, for estimating equity value. In contrast, dividends are not direct measures of performance. However, while theory tells us that there need not be any relationship between current dividends and expected future dividends, there is the possibility that management can use dividend policy to signal their view of the company's prospects. In practice, the primary users of earnings and dividend information are stock market analysts. Sell‐side analysts in investment banks generate and publish earnings forecasts ... log in or subscribe to read full text