Thesis: Stock prices are very weird, and I’m skeptical if prices can be explained solely by the CAPM.
Stock prices are supposedly based off of the Capital Asset Pricing Model, and can be further reduced to all expected discounted future dividends. There are some exceptions, such as Berkshire Hathaway, who’s CEO says, 1“Although it does not pay a dividend, Berkshire Hathaway distributes money directly to shareholders though its generous stock buybacks.” For most companies, the dividend pay out is expected to increase, as their net income increases. And the reverse, the dividend pay out is expected to decrease, as their net income decreases.
However, this is often times not the case, as companies may opt to reinvest cash rather than increase dividends. And in the latter case, companies refuse to lower dividends despite decreases in income. It seems that companies with lower payout ratios actually have higher price to earnings ratios when compared to companies with higher payout ratios. This is because the majority believes that this higher growth will result in higher dividends over time.
Let’s take a look at Apple2, which has consistently had between 1.5 and 3% yield since 2012. (It stopped paying dividends between 1995 and 2012)
Over the past few quarters, Apple has shown significant EPS growth, and when compared to the dividend rate3, it far exceeds. Despite this fact, Apple has restricted its dividend growth. While one may make the argument that Apple is simply reinvesting its capital to growth the companies book value, it doesn’t make sense that its market value increase exponentially more rapidly than the dividend rate.
If this practice continues for the entirety of Apple’s life, then the book value gains are never equivalently realized for someone who holds the stock for the entirety of Apple’s life. And if Apple doesn’t continue this practice, then investors may see this as a sign of slowing growth. It is shown that investors care more about growth than dividends as indicated initially when dividends didn’t properly reflect earnings growth. So why do people drive the price up in proportion to earnings rather than dividends.
I believe that this can be attributed to the castle in the air theory depicted in A Random Walk Down Wallstreet. “A thing is worth only what someone else will pay for it.” This brings us back to the CAPM, where capital gains make up half of the formula.
And so a self fulling prophecy arises; if enough people believe that the price will rise, the price rises as they buy, and then more people get on board.
It is possible that some of the inflation of price is due to its risk free rate of return, but when compared to a close competitor, Microsoft, it still doesn’t hold.
And one may argue that book value also plays an important factor, but I believe that book value isn’t a big driving factor, as we can see when looking at Bank of America, trading around half book value.