Method 4F – Forward-Looking Dividends Method

¹¹ Stock Market Returns in the Long Run

The forward-looking dividend model is also referred to as the constant dividend growth model (or the Gordon model), where the expected equity return equals the dividend yield plus the expected dividend growth rate. The supply of the equity return in the Gordon model includes inflation, the growth in real dividend, and dividend yield. As is commonly done with the constant dividend growth model, we have used the current dividend yield of 1.10%, instead of the historical dividend yield of 4.28%. This reduces the estimate of the supply of equity returns to 5.44%. The equity risk premium is estimated to be 0.24%. Figure 8 shows the equity risk premium estimate based on the earnings model and the dividends model. In the next section, we show why we disagree with the dividends model and prefer to use the earnings model to estimate the supply side equity risk premium.

Differences Between the Earnings Model (3F) and the Dividends Model (4F)

There are essentially three differences between the earnings model (3F) and the dividends model (4F). All of these differences are reconciled in the two right bars (4F’) in Figure 8. These differences relate to the decrease in the historical payout ratios, the low current payout ratio, and the high current P/E ratio.

First, the earnings model uses the historical earnings growth to reflect the growth in productivity, while the dividend model uses historical dividend growth. Historical dividend growth underestimates historical earnings growth because of the decrease in the payout ratio. Overall, the dividend growth underestimated the increase in earnings productivity by 0.51% per year from 1926 to 2000.

¹² Stock Market Returns in the Long Run

The second difference is also due to the lowered payout ratio as reflected in today’s current yield. This payout ratio is at a historic low of 31.8%, compared to the historical average payout of 59.2%. Applying such a low rate forward would mean that even more earnings would be retained in the future than in the historical period. Had more earnings been retained, the historic earnings growth would have been 0.95% per year higher. Thus, it is necessary to adjust the 1.10% current yield upward by 0.95% to give the 2.05% shown in the figure.

Using the current dividend payout ratio in the dividend model, 4F, creates two errors, both of which violate Miller and Modigliani (1961) theory. The firms’ dividend payout ratio only affects the form in which shareholders receive their returns, (i.e. dividends or capital gains), but not their total return. Using the low current dividend payout ratio should not affect our forecast, thus the dividend model has to be upwardly adjusted by both 0.51% and 0.95%, so as not to violate M&M Theory. Firms today likely have such low payout ratios in order to reduce the tax burden of their investors. Instead of paying dividends, many companies reinvest earnings, buy back shares or use their cash to purchase other companies.¹¹

The third difference between models 3F and 4F is related to the current P/E ratio (25.96) being much higher than the historical average (13.76). The current yield (1.10%) is at a historic low both because of the previously mentioned low payout ratio and because of the high P/E ratio. Even assuming the historical average payout ratio, the current dividend yield would be much lower than its historical average (2.05% vs. 4.28%) This difference is geometrically estimated to be 2.28% per year. The high P/E ratio can be caused by 1) mis-pricing; 2) low required rate of return; and/or 3) high expected future earnings growth rate. Mis-pricing is eliminated by our assumption of market efficiency. A low required rate of return is eliminated since we assume a constant equity risk premium through the past and future periods that we are trying to estimate. Thus, we interpret the high P/E ratio as the market expectation of higher earnings growth.¹²

¹³ Stock Market Returns in the Long Run

To summarize, there are three differences between the earnings model and the dividends model. The first two differences relate to the dividend payout ratio and are direct violations of the Miller & Modigliani (1961) theorem. We interpret that the third difference is due to the expectation of higher than average earnings growth, predicted by the high current P/E ratio. These differences reconcile the earnings and dividend models. Equation 25 presented model 4F’, which reconciles the difference between the earnings model and the dividends model.

Date: 2016-01-14; view: 576