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, we investigate the relationship between the actual values and our estimated intrinsic values of the S&P Composite Index. We estimate the intrinsic value using the most fundamental valuation technique, the dividend discount model based on an estimated 30-year rolling equity premium and corresponding cost of equity combined with 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 across both periods well-known economic and price-based factors can explain much of the levels and changes in "pricing errors". Over this period the Fed Model also finds equities were under-valued, but its predictive ability decreases when one considers other factors. Because of the concerns surrounding the choice of discount rate in asset pricing research, we compare our estimated cost of equity (using the CAPM) with implied measures from the actual price and dividend series and observe that many of the differences are related to economic conditions.

Keywords: Asset pricing, valuation, dividend discount model, multi-factor models

JEL Classification: G21, G35