Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 29 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 29

We consider the actual prices and dividend payments for the S&P Composite Index over the

period from 1871 to 2003. We find that our dividend-based valuation methods perform relatively well at

explaining the actual prices for the S&P Composite Index over our sample period. When considering the

differences between the actual price levels for the Index and the expected prices obtained using the DDM

and the GGM, we find that these differences are frequently related to changes in economic conditions. In

particular, we find that the expected price appears to under-estimate the actual price in periods of

economic expansion but the opposite occurs during economic contractions. Because these results could

be related to either our underestimation of the future dividends in periods of economic expansion or our

over estimation of the cost of equity at these times, we consider this more carefully.

Specifically we explore the role of our economic factors in explaining the equity risk premium

and dividend growth rates at the heart of the DDM and GGM. Because of historical information used to

estimate the cost of equity, we find that our estimated cost of equity does not react as quickly to changes

in economic conditions as the implied cost of equity used to equate the actual price and the expected price

using the DDM and GGM. These results further suggest that economic conditions play an important role

in how investors appear to set the required return for equity – as economic conditions worsen, investors

require a higher return and this is captured in the implied cost of equity. As a consequence our analysis

provides some new insights into how the economic factors used in most empirical asset pricing tests may

be related to how investors value equity investments.

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 29