Chapter 2 introduces a simple valuation to make the point that a P/E ratio indicates not only earnings growth but also the risk to earnings growth. These are the r and g features of the simple valuation model:
and thus
But the chapter warned: Don’t use it! It’s just to make a point.
With the discussion of M&M dividend irrelevance in chapter 3, you now see why. Retention (less than full payout of earnings with dividends) keeps assets in the firm and those assets generate earnings growth. But the added earnings from retention might not be value added earnings. Retention adds value only if invested in value-adding assets, so dividend payout in itself is irrelevant to value. The g in the simple model enters as value relevant, increasing price, but the growth might just come from retention that does not add value. That is why it was said that the simple model works only with full payout of earnings.
In contrast, the residual earnings model is dividend irrelevant, as explained in chapter 3. It requires earnings that add value by covering the required return.