Payout Policy Relevance and Accounting‐Based Valuation

27 Pages Posted: 10 Dec 2014

See all articles by Colin Clubb

Colin Clubb

University of London - King's College London - Department of Management

Martin Walker

University of Manchester - Manchester Business School

Multiple version iconThere are 2 versions of this paper

Date Written: December 2014

Abstract

DeAngelo and DeAngelo (2006) (D&D) argue ‘payout policy is not irrelevant and investment is not the sole determinant of value, even in frictionless markets’. Consistent with this view, we argue that the concept of a perfect capital market in Miller and Modigliani (1961) (M&M) and Fama and Miller (1972) can be extended to allow for managerial moral hazard if managers are assumed not to participate in securities trading. An updated version of the M&M valuation model is presented and the possibility of managerial free cash flow (FCF) retention through operating expense manipulation and sub‐optimal investment policies is discussed. Our analysis supports D&D's argument that payout policy is relevant and indicates that value relevance of payout depends on the quality of earnings measurement and the optimality of investment policy. Following this, we develop a framework for analyzing valuation and informational roles of payout in accounting‐based valuation models and apply this framework to the Ohlson (1995) and Feltham and Ohlson (1996) models. This analysis shows how these models permit payout valuation relevance due to managerial FCF retention but not payout informational relevance. Finally, we consider how the Feltham and Ohlson (1996) model can be extended to incorporate time variation in expected profitability of capital investment caused by time variation in managerial FCF retention activities and show that this explicitly affects payout value relevance. We conclude that the development of models where payout plays an explicit valuation role due to issues of moral hazard is an important direction for future research.

Keywords: Free cash flow retention, Payout policy, Perfect capital markets accounting‐based valuation.

Suggested Citation

Clubb, Colin and Walker, Martin, Payout Policy Relevance and Accounting‐Based Valuation (December 2014). Abacus, Vol. 50, Issue 4, pp. 490-516, 2014, Available at SSRN: https://ssrn.com/abstract=2536168 or http://dx.doi.org/10.1111/abac.12038

Colin Clubb (Contact Author)

University of London - King's College London - Department of Management ( email )

150 Stamford Street
London, SE1 9NN
United Kingdom

Martin Walker

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

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