Nobel laureates: Merton Miller

Miller and Modigliani's theorems embody important insights for investors regarding corporate leverage, dividends, and total returns.

Paul Kaplan 5 September, 2018 | 5:00PM

 

 

I'm Paul Kaplan, research director at Morningstar Canada.

In two previous videos, I looked back on two of the three laureates of the 1990 Nobel Prize in Economic Sciences, Harry Markowitz and William F. Sharpe. Today I look back on the major contributions of the third 1990 Nobel laureate: Merton Miller.

Miller was awarded the Nobel for the work that he did jointly with Franco Modigliani in the late 1950s and early 1960s in corporate finance. (Modigliani had already won the Nobel Prize in 1985 in part for his work with Miller.)

The Nobel committee cited two theorems put forth by Miller and Modigliani. The first, the capital structure invariance theorem, states that under certain conditions, the total value of a firm -- that is, not just its stock market value but the market value of both its debt and its equity -- is not affected by how it chooses to finance its activities, whether through debt or equity.

This has important implications for equity investors. Firstly, it implies that equity investors should analyze a company's financial picture as a whole, rather than just the dividends on the stock it issues. But stock investors need to take into consideration the company's capital structure -- that is, how much debt financing the company is using. Debt financing, or how much leverage the firm uses, amplifies the risk and return of the company's stock.

The reason that leverage doesn't affect total company value is that stock holders can set their own level of leverage on the company within their own portfolios by holding the company's debt.

The idea that investors aren't bound by a company's financial policy is the basis for Miller and Modigliani's second theorem: the M&M dividend irrelevance theorem. This theorem states that in the absence of taxes and other frictions, a company's dividend policy has no impact on its value. This is because investors can undo a company's dividend policy within their own portfolios. For example, investors who hold a dividend-paying stock but doesn't want dividends could use the dividends to purchase more shares of the same company. Conversely, investors who hold a stock that doesn't pay dividends but want to receive dividends can create "homemade dividends" by selling shares of that stock.

The bottom line for equity investors of the dividend irrelevance theory is that they should focus on total return, rather that the components of total return -- price changes and dividend payments -- separately.

While the M&M theorems do not hold in the real world because of taxes and market imperfections, they do embody important insights for investors regarding corporate leverage, dividends, and total returns. Investors would be wise to apply their lessons, especially when investing in stocks.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.