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1 June 2014 CFA Institute Journal Review

Dividend-Price Ratios and Stock Returns: International Evidence (Digest Summary)

  1. Aditya Jadhav, CFA

In the United States, the dividend–price ratio has the ability to forecast future returns but not future dividend growth. For every 1 percentage point rise in dividend yield, market prices rise by more than 5 percentage points. This relationship is statistically insignificant in other countries, such as Germany, Italy, and Sweden.

What’s Inside?

The Gordon growth formula can be written in the form of the dividend–price ratio as (Dt/P0) = Rg, under the assumptions that future dividends will grow at a constant rate (i.e., g) forever and that the expected returns on equity (i.e., R) will never change. The ability of this ratio to predict future returns is a question of widespread debate among both academics and market participants because some believe that the dividend–price ratio is a predictor of future dividend growth. Empirical research has revealed that the dividend–price ratio can forecast future returns because the ratio is high when expected returns are likely to be high and vice versa. But as the author hypothesized in previous work, the relationship is dependent on the volatility of real dividend growth.

How Is This Article Useful to Practitioners?

This article is an updated study on the international relationship between dividend–price ratios, real dividend growth rates, and real stock returns. Any financial ratio that has the ability to predict future returns is a topic of interest not only to investors but also to scholars. Although a lot of empirical research has been done in the United States to prove that the dividend–price ratio has significant predictive power for future returns, the predictability of future returns will vary across countries and over time.

Practitioners, such as portfolio managers, may consider using investment strategies that benefit from the predictability of the dividend–price ratio in some markets.

How Did the Author Conduct This Research?

The author uses data for 10 countries that had relatively developed capital markets throughout the period from 1951 to 2012. The main objective of using the data starting from 1951 was to avoid the anomalies associated with the post-war rebuilding in Europe and Japan and the Great Depression of 1929. The data consist of annual real stock returns on each country’s primary market index, the dividend–price ratio for that particular index, and the annual real rate of dividend growth provided by Research Affiliates.

The author hypothesizes that the predictability of future returns based on dividend yield is not a global characteristic but a historical fact of the US economy that ex post, long-run, real dividend growth mirrors the long-run real GDP growth rate of 3% a year.

In his first equation, the author regresses real returns on the dividend–price ratio, whereas in his second equation, annual dividend growth rates are regressed on the dividend–price ratio. With respect to the US market, for every 1 percentage point increase in dividend yield, market prices rise by about 5 percentage points, which is statistically and economically significant. A similar positive relationship between future stock returns and the dividend–price ratio is also documented for the other nine countries, albeit statistical significance is found only in the United Kingdom, Japan, and Australia. In other countries, such as Canada, Sweden, Germany, Italy, and Spain, which have the highest dividend growth volatility, the dividend–price ratio does not have significant predictive power.

The author also documents that when the volatility of real dividend growth is low, future returns are more predictable. But regression results indicate no statistical relationship between dividend growth and the dividend–price ratio in the US market. The dividend–price ratio is only a significant predictor of dividend growth in Germany, Italy, and Sweden.

Abstractor’s Viewpoint

The top 10 developed capital markets for which the author tests his hypothesis have undergone drastic changes in their economic structures during the period of 1951–2012. A better approach would have been to test the hypothesis on the economy after it was classified as a developed economy because research has shown that dividend growth rates are more stable once an economy is in the maturity phase compared with when it is in the growth phase.

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