Dividends and Stock Valuation: A Study From the Nineteenth to the Twenty-First Century

Abstract

Using a comprehensive database of monthly U.S. economic and price-based factors from 1871 to 2005 (to the best of our knowledge, the longest such monthly database), we investigate and provide a new perspective for how changing economic conditions have impacted the relationship between the actual and intrinsic values of firms in the S&P Composite Index. We estimate the intrinsic value of equity using the most fundamental valuation technique, the dividend discount model and compare this series to actual prices in order to estimate “pricing errors. ” Based on a 30-year rolling cost of equity estimate and perfect foresight of dividends, we find that stocks were undervalued, on average, by approximately 26% over the entire sample. Prior to 1945, stocks were consistently undervalued and displayed more bond-like characteristics. Since 1945, stocks were, on average, fairly valued but with long periods of under - and over-valuation. We show that well-known economic and price-based factors can explain much of both the level and changes in pricing errors. We find that equities were under-valued using the well-known Fed Model, but this undervaluation has decreased over time and the predictive ability of the Fed Model decreases when one considers other factors. We also compare estimated measures of the cost of equity (based on the CAPM) with implied measures from the actual price and dividend series and are able to explain much of the differences as relating to economic conditions.