Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 3 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 3

1. Introduction

Long horizon historical studies allow researchers to understand how firm and investor behaviors

have changed over time and across economic conditions. In this study, we investigate the changing role

of dividends from the 1870s to 2003. This period allows us to consider how the role of dividends in the

valuation of equity has changed as equity markets in the U.S. have matured and economic conditions

changed. Since firms typically pay dividends as a means of returning profits to their providers of equity

capital, the fundamental value of a firm’s equity should be related to its expected future dividend

payments. The motivation for this is well-expressed in the following quote from Williams (1938):

“... a stock is worth the present value of all the dividends ever to be paid upon it, no

more, no less... Present earnings, outlook, financial condition, and capitalization should

bear upon the price of a stock only as they assist buyers and sellers in estimating future

dividends.”

Building on this concept, several studies have investigated the ability of changes in dividends to explain

changes in asset prices (e.g., Shiller (1979 and 1981) and Cooley and LeRoy (1981)). Because the results

of such tests have been mixed, researchers have proposed a wide variety of asset pricing models to try to

empirically understand how different factors influence equity prices.

The goal of this study is to improve our understanding of how investors value firms by focusing

on the role of dividends and how this role changes as economic conditions change. This differs from the

standard research in asset pricing which focuses on the ability of diverse economic risk factors to explain

the observed returns for various financial securities. Because our study focuses on the fundamental value

of equities provided by dividends, we obtain new insights into what factors influence how investors value

securities. We begin by comparing actual equity values to those predicted using two of the most

commonly used fundamental valuation methods – the basic dividend discount model (DDM) and the

constant growth version also referred to as the Gordon growth model (GGM). Studying the differences

between the actual and expected prices over time and over different economic conditions provides us with

insight into the roles of different economic factors in how investors value assets. The second stage of the

analysis considers how changing economic conditions impact the relationships between the estimated and

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 3