Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 22 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 22

subsequent analysis we use the cost of equity using the cumulative market returns.

Figure 3b presents

the results for the expected price obtained from the GGM using the estimated historical nominal growth

rate in the GNP as our estimate of the future dividend growth rate. This is arguably a more accurate

estimate for the expected future dividend growth rate for a perpetuity than the alternative measure of the

average historical dividend growth rate. This model performs well at explaining the actual prices with a

much lower variance around the actual price than using a dividend growth rate obtained as the moving

average of the past actual dividend growth rates. Consequently, we use the growth rate based on the GNP

in our subsequent analysis.

To formally study what factors appear to influence the differences between the expected and

actual prices, Table 4 presents the results for the regressions of the unexplained price differences (UP1,

UP2 and UP3) and our economic factors using equation (9). The results in the first panel of Table 4 are

for the UP1 regressions. Over the entire sample period the results demonstrate that our measures related

to the outlook for the economy (the default premium and the term structure) are both positively related to

the difference between the expected and the actual prices. This suggests that the expected price obtained

using the fundamental valuations are higher than the actual prices as the default premium and term

structure increase. If we assume the default premium increases as the risk in the economy is increasing

(BBB rated firms are required to pay a higher premium to borrow as the economy is performing worse)

and the term structure increases as the economy is becoming riskier (the short-term interest rate falls as

the economy enters a downward cycle), these results suggest that our fundamental valuation over-

estimates the price of the stock as the economy is entering a downturn. Since the fundamental valuation

relies on assumptions to estimate the expected dividend stream and the cost of capital, this finding

suggests that either the cost of equity used in our model is too low going into this period (it does not

adequately reflect the increased risk that the market is going to be facing during the downturn) or actual

dividends are higher than one would have been able to predict at this time so the dividends reflected in the

Note: we also consider a moving average of the past 30 years as an alternative means of calculating the market

risk premium and thus the cost of equity. Because the results are not qualitatively different from those using the

cumulative returns, to conserve space only one is presented.

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 22