Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 5 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 5

conditions. In particular, we find that the expected price appears to under-estimate the actual price in

periods of economic contraction but the opposite occurs during economic expansions. Because these

results could be related to either our underestimation of the future dividends in periods of economic

contraction 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 the use of historical information 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 therefore 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. The paper is

organized as follows. Section 2 provides a review of the dividend-related literature relevant for our study.

Section 3 presents our models and describes our hypotheses. Our data are described in section 4. Results

are presented in section 5. Finally, conclusions are presented in section 6.

2. Background

In this section we discuss some of the literature on how investors value assets. We start with the

valuation models based on dividends. Since one of the key inputs into these models is the discount rate,

we follow this with a review of some of the literature on the market or equity premium and its

relationship to the work in asset pricing .

2.1 Investor Valuation of Dividends

The most intuitive means for determining the value of the equity of a firm is the DDM. This

model states that the present value of an asset can be measured as the discounted value of all of the future

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 5