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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).
[G21, G35]
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...