Payout Policy Relevance and Accounting Based Valuation

Abstract

DeAngelo and DeAngelo (2006) (D&D hereafter) argue that ‘payout policy is not irrelevant and investment is not the sole determinant of value, even in frictionless markets.’ We first re-examine their critique using M&M’s (1961) multiperiod valuation framework and identify non-essential operating cash expenses as an important mechanism for managerial free cash flow (FCF) retention, thus confirming D&D’s argument that payout policy is relevant and demonstrating the role of both earnings measurement and investment policy in an effective payout policy. Second, we develop a general analysis of the valuation and informational roles of FCF payout in a perfect capital market and apply this framework to the well-known accounting valuation models of Ohlson (1995) and Feltham and Ohlson (1996), showing 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 model embeds both payout value relevance and payout informational relevance. We conclude that, while research on accounting valuation models based on the assumption of payout valuation irrelevance is of theoretical and practical interest, the development of models where FCF payout plays an explicit valuation and informational role due to issues of moral hazard is an interesting and important direction for future research.