Dividend yield, does it matter?

Based on Fast Forward case.

What is risk premia?

• P(t)=Div(t+1)/(r-g)=Div(t) (1+g)/(r-g)

• P(t+1)=Div(t+2)/(r-g)=P(t)*(1+g)

• Thus, Exp. Returns = DivY *(1+g) +g

• Risk premia = DivY *(1+g) +g –Rf

• But g Rf => Risk premia DivY *(1+ Rf)

Another argument: valuation ratios shold be within some bound

• Conventional efficient market theory: prices are random walk.– Thus, neither D/P nor P/E ratios should not

have any forecasting power.

• But if we will accept that for whatever reason DivY should be within some bound, then either numerator or denominator should move in a way that makes market variables forecastable. Then what moves?

Dividend Yield

0

0.02

0.04

0.06

0.08

0.1

0.12

1870 1890 1910 1930 1950 1970 1990 2010

Long-termMean DivY=4.65%

Till next mean crossing...

(a bit of cheating...)

• Poor job for Div growth forecasting, R2=0.25%

• Good job for price growth forecasting R2>30%

• Thus, it is DENOMINATOR that brings back DivY within ”decent” range

One year horizon• Div growth is fairly

predictable, R2=13%

• Price changes are almost not predictable, R2 is about 1%

Ten years Horizon

• R2=1% for DivG and 16% for PriceG.

• Note that DivG results are not really explainable within eff. Mkt theory at all.

• Based on that, within next 10 yrs we should expect 55% drop in S&P

P/MA10(E)

0

5

10

15

20

25

30

35

40

45

50

1880 1900 1920 1940 1960 1980 2000

Forecasting from P/smoothed E

ratio

• R2 for price growth regression is high (40%)

• Superior to DivY• Forecast is really

bad..

• We cannot forecast productivity growth....

Anything new happened within the last 30 years? Share buybacks

• Share repurchases have tax advantages w.r.t. paying simple dividends.

• Part of earnings that can be used for dividend payout is now smaller and DivY is underestimated w.r.t. similar number 50 years ago

• What difference does it make?

Cole, Helwege & Laster,FAJ 96

Assuming both buybacks and new issues are done at market prices, significant adjustment for DivY is necessary

Cole, Helwege & Laster,

FAJ 96 (2)• Adjustment of 0.8% in

96.• Problem: most of

options are issued at below mkt price. Liang and Sharpe: for 144 S&P500 firms in 97 adjustment is 1.39%, in 98 0.75%

Hard assets and financial claims diverge

Intangible investmenst (1)

• ”New economy” involves substantial investments in intangibles.

• Accounting procedures do count activity to promote web site as expenses but ”...they are really investments”. Hall (2000) called it e-capital.

• McGrattan &Prescott : understatement in earnings are about 26%

Intangible investmenst

• McGrattan &Prescott : – understatement in earnings are about 26%– Fits only last couple of years

• Bond & Cummins: if intangibles are counted as R&D and marketing, then for 459 industrial firms 82-98 still there is no explanation of overvaluation.

Demographic changes

• Affluent society is formed

• Baby boomers are educated, have money to invest and need to save for retirement (uncertainties related to Social Securities, etc. )

• Thus, one-time shift in risk premium.

Inflation

• Responce to inflation is not always rational. Modigliani & Cohn 79: People discount dividends not at real, but at nominal rate. Thus, when inflation is high, stock market is undervalued, and when it is low, stock mkt is overvalued.

• Now CPI is low...

International Evidence: Mixed

What else Dividends can tell us?

• Let us consider 2 variables: Prices and dividends.• Gordon/Shapiro says, that • P(t)=E(k D(t+k) *(1+r)-k)P*(t)• P*(t)=P(t)+(t), assume E((t)| P(t))=0• =>cov(P,P*)=cov(P,P)+cov(P, )=var(P)• -1<Cov(P,P*)/(StdPStdP*)<1• => Std(P)/Std(P*)<1=> std(P)<Std(P*)• Volatility of forecast (prices) should be smaller than

volatility of payouts (dividends). But the relationship is exactly opposite!!!!