Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 21 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 21

We extend the graphical analysis by considering the summary statistics for our variables in Table

2. The results in this table illustrate the large variation within each of these factors over our sample

period. This significant variation allows us to use these factors to try to explain our valuations. Table 3

presents the correlations between our factors.

Interestingly, we find that the default premium is

negatively correlated with the term structure. Since the default premium and term structure are both

believed to increase as the economic risk increases, this result suggests that these factors may react to

changes in economic conditions at different rates, consistent with our graphical results. As discussed

earlier it appears that the changes in the term structure (default premium) lead (follow) the changes in the

economy as measured by the GNP. The changes in the level of the CPI, on the other hand, appear to

closely follow the economy – falling as GNP falls and rising as GNP rises.

5.2 The Dividend Discount Models

In this section we investigate the ability of valuation techniques using expected future dividends

to determine the actual value of the S&P Composite Index. The analyses in the previous section suggest a

possible relationship between dividends and prices, so we now explicitly investigate the role of expected

future dividends in determining how investors determine share prices. If dividends are valued by

investors, we should be able to use expected dividends to determine the current value of equities. We do

this using the DDM. Since we have a long series of dividends, we have an ideal situation within which to

test how well this model works in practice. We employ two forms of this model: a model which

discounts each of the future expected dividends as in equation (2), and a model which assumes a constant

growth rate to determine the future expected dividends, as in equation (5), the GGM.

Before formally examining the prices estimated by each model, Figure 3a illustrates how the expected

prices obtained from the DDM perform at explaining the actual prices over our sample. We can see that

the DDM appears to perform reasonably well at estimating the true prices over the sample regardless of

the methodology used to estimate the cost of equity. It does appear that the expected prices calculated

using the cost of equity estimated using the cumulative returns performs slightly better in general. In the

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 21