Chapter 7: Sources of Shareholder Value

The value of a stock comes from the future cash flows that investors expect to receive by owning it. These cash flows include dividends and proceeds from share buybacks or liquidation. Because investors prefer cash sooner rather than later, these expected future cash flows must be discounted back to their present value using an appropriate discount rate.

Future cash flows are worth less than cash today due to time value of money and investment risk. Discounting adjusts for this by reducing the value of future payments based on how long you'll have to wait and how uncertain they are. The longer the wait and the greater the risk, the higher the discount applied.

1. The risk-free rate, which reflects the return on safe investments like government bonds.

2. A risk premium, which compensates investors for the uncertainty and potential variability in a stock’s future returns. Together, they form the required return on equity, also known as the cost of equity.

Companies return value to shareholders through:

• Dividends: direct cash payments.

• Debt reduction: lowering interest expenses.

• Reinvestment: funding new projects to grow future earnings.

• Buybacks: reducing outstanding shares, which increases earnings per share and the value of each remaining share.

Buybacks reduce the number of shares outstanding, which increases earnings per share and potentially boosts the stock price. For remaining shareholders, it’s like an automatic reinvestment that increases their ownership share without requiring them to buy more stock. Over time, this can lead to higher capital gains.

Buybacks are often preferred because they’re more tax-efficient. Capital gains from rising share prices (caused by buybacks) are taxed only when the shares are sold, and usually at lower rates than dividends. Additionally, buybacks can signal confidence from management and offer flexibility compared to fixed dividend payments.

Not necessarily. Firms generally pursue buybacks only when they don’t have investment opportunities that exceed their cost of capital. In fact, evidence suggests markets sometimes penalize firms for over-investing. So buybacks don't crowd out valuable investment—they simply reallocate excess capital.

Price = Dividend / (Discount Rate – Growth Rate)This formula assumes dividends grow at a constant rate indefinitely. It shows that stock prices are sensitive to changes in expected dividends, required returns, and dividend growth. Higher expected growth or lower discount rates push stock prices up.

Not if the firm earns the same return on retained earnings as on other equity. Whether a firm pays out earnings as dividends now or reinvests them for future growth, the present value of total returns remains the same. Dividend policy affects the timing of returns, not their total value.

Lower current dividends reduce immediate cash to shareholders but increase retained earnings, which can be reinvested to grow future dividends. If the return on reinvested earnings equals the cost of equity, the total value of the firm remains unchanged, and shareholders benefit through increased capital gains over time.

Buybacks remove shares from the market, increasing each remaining share’s claim on earnings. This raises future dividends and earnings per share, similar to the effect of reinvesting dividends into additional shares. The investor’s ownership stake increases over time, even without receiving a cash payout.

Earnings only matter if they lead to actual cash flows to shareholders, like dividends or buybacks. Valuing a stock based solely on future earnings overstates its true value because not all earnings are necessarily distributed. Only distributed or expected-to-be-distributed cash flows should be considered in valuation.

Williams argued that dividends, not earnings, are the proper basis for stock valuation. If retained earnings never lead to future dividends or payouts, they don’t add value. Earnings are only valuable if they eventually translate into cash returned to shareholders.

Even though it doesn’t pay dividends, Berkshire Hathaway generates significant cash flow and can reinvest it effectively or use it for buybacks. If it ever fails to do so, investors could take control and extract value through dividends or asset sales. The potential for future cash payouts supports its valuation.

Post-WWII, companies reduced dividend payout ratios from around 67% to 49%, which allowed them to retain more earnings. This led to faster growth in earnings and capital gains, even though dividend yields fell. The shift aligns with financial theory: lower dividends today can lead to higher total returns over time.

Because dividends and long-term returns depend on sustainable profits. Earnings are a key signal of a company’s ability to generate future cash flows — but they must reflect true, ongoing profitability, not just accounting results.

GAAP (Generally Accepted Accounting Principles) earnings are official, standardized earnings calculated using strict accounting rules. They tend to be conservative and can appear very volatile, especially during recessions, due to rules like mark-to-market accounting and the lack of upward reversals.

These earnings exclude certain non-recurring items like asset write-downs and severance costs. They offer a more stable and representative view of a company’s core business performance than GAAP earnings.

Because they can distort the true economic performance of a business — especially during downturns. GAAP rules force write-downs in bad times but don’t allow reversals when conditions improve, which can understate long-term earnings power.

They declined more sharply than during the Great Depression, despite a smaller fall in GDP. This extreme volatility was largely due to strict accounting rules, not necessarily true declines in economic value.

It means a company reports earnings above what analysts expected. This can drive the stock price up, especially if the company had previously guided expectations lower to make it easier to surprise positively.

Whisper numbers are unofficial, insider-based earnings expectations that investors believe are more accurate than consensus analyst estimates. Markets often react based on whether actual earnings beat or miss these whispers.

Because many firms actively manage their earnings to slightly exceed expectations, knowing that even a one-cent surprise can lead to a positive market reaction. This behavior is observed in 70–75% of firms.

Investors also focus on revenue growth, profit margins, and especially forward guidance — the company's outlook for future performance — since these factors often have a stronger impact on stock prices than past results.