Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century (Page 6 of 45) in pdf

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 6

expected dividend payments. Building on this intuition, Gordon and Shapiro (1956) and Gordon (1962)

present a special case of the general model, the GGM, whereby the value of the firm’s equity can be

represented as a growing perpetuity based on next period’s expected dividend.

Even though our

discussion focuses on these models, we recognize that there are many alternative models such as multi-

stage growth models. Since these models are based on the fundamental idea that an asset is worth the

discounted value of all of the future cashflows it can generate, these models are the most commonly used

by both academics and practitioners.

Since these models imply that changes in dividends should explain changes in asset prices,

several studies have considered how well changes in dividends can explain changes in the volatility of

asset prices (e.g., Shiller (1979 and 1981) and LeRoy and Porter (1981)). These tests build on the

intuition that since asset prices are determined by the discounted value of future dividends, prices and

dividends should have similar volatility. Because they find that prices are excessively volatile when

compared to the implied prices based on dividends, the results of these tests have cast doubt on the role of

dividends in explaining the value of equity. However, the results from subsequent studies which have

relaxed several of the assumptions used in the original tests have been more favorable and suggest that

dividends do play a significant role in determining the value of equity (e.g., Bollerslev and Hodrick

(1995)).

Several studies have tried to explain the negative findings of the studies such as those of Shiller

and LeRoy and Porter. Poterba and Summers (1988), for example, study the risk premium but find that

the magnitudes and variability in the implied risk premiums necessary for prices to be related to dividends

are too large to be consistent with any rational, fundamental asset pricing model. On the other side of the

debate, Fama and French (1988) find that the variation in dividend yields explains a large proportion of

multi-year return predictability. Although many subsequent studies continue to find evidence in support

of the predictive ability of dividends for equity returns, studies using longer time series of data bring the

generalizability of these results into question – the predictive ability of the dividend ratio appears to be

Dividends And Stock Valuation: A Study From The Nineteenth To The Twenty-First Century Page 6