The Dividend Discount Model in the Long-Run: A Clinical Study

Article excerpt

Finance professionals frequently value assets using fundamental valuation methods which discount the expected cash flows received by investors. Using information on the share price, dividend payments, and earnings for a single firm over a period of more than 120 years, we compare the actual share price to the expected price-calculated using several of the most commonly used fundamental valuation methods. Since these methods depend on the estimation of inputs-such as the discount rate and growth rate-we discuss the sensitivity of the expected prices to different estimation techniques and the relevant assumptions across various economic conditions. Over our entire sample period, we find that dividend-based models perform well at explaining actual prices; they perform better than commonly used earnings-based models (such as the Fed Model).

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The fundamental value of an asset can be viewed as a function of three variables: the size, timing, and uncertainty of the cash flows the asset will generate for investors over its lifetime. For equities, the cash flows are generally dividends and the uncertainty lies in the timing and growth of the firms' earnings and its subsequent ability to pay dividends. Since dividends historically have depended on the size and sustainability of earnings, both dividends and earnings are key determinants of the value of equity. For example, Lintner (1956) interviewed managers from 28 companies to determine how and why their firms paid dividends. He found that managers target a long-term payout ratio (dividends as a percentage of earnings). Even though recent studies, such as Brav et al. (2005), suggest that managers now focus on maintaining a steady growth rate of dividends rather than a consistent payout ratio, dividends, and earnings continue to play a key role in discussions (among both academics and practitioners) about how to value equity. In this article, we provide a detailed evaluation and comparison of several commonly used methods for the valuation of equity in order to explore their performance over time and various economic conditions.

To most effectively investigate how different factors influence these valuation techniques, we study data on a single firm which has regularly paid dividends over a long period. (The firm studied has, to our knowledge, the longest continuous available dividend stream of any North American firm.) The first set of models we consider are versions of the standard dividend discount model. Though some empirical studies find that investors consider dividends when valuing assets (e.g., Fama and French, 1988 or for a survey see Alien and Michaely, 2002), there is little consensus over longer periods of time (e.g., Goyal and Welch, 2003). The next set of models we study are based on earnings, such as the well known "Fed Model."

Focusing on only one firm, we recognize that there is an issue of generalizability; thus, our results are not meant to present a definitive statement about the applicability of these models to the pricing of all assets. There is, however, an important corollary: if the dividend discount model and earnings-based models do not appear to be appropriate to the one firm to which they should have the greatest chance of applying, then these models may be of questionable value to practicing managers. To investigate the robustness of these valuation techniques for changing economic conditions and different assumptions, we compare their performance and their sensitivity to the assumptions used when implementing them in practice over periods characterized by a wide variety of economic conditions.

We focus on the Bank of Montreal because it is historically one of the most preeminent banks in North America and has consistently paid a regular dividend.1 This status allows us to study the earnings and dividend payout behavior of a firm in the same industry over a very long period of time. The payment of a regular dividend is important since many of the valuation techniques we consider are based on the fundamental concept that a firm is worth the discounted value of the future cash flows (i. …