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Dividends play a central role in traditional models of stock valuation. In such models, stocks have value because they hold the promise of future cash payouts. Dividends constitute the primary cash payment to stockholders-the greater the expected future stream of dividends, the greater the value of the stockholder's share.
The dividend yield equals a stock's total dividends per share over the most recent four quarters, divided by the current price of the stock. The resulting number is represented as a percentage and thus is comparable to an interest rate. Figure 1, showing the dividend yield on equities since 1871, reveals a striking decline in this measure over the past decade. The dividend yield now stands at around 1 1/4 percent, a near-record low. What explains this 10-year decline?
To address this question, it is important to understand that the dividend yield is only one part of a stock's return. Another element of return derives from appreciation in the price of a stock. Price appreciation is typically realized when firms reinvest earnings and achieve higher earnings growth that allows higher future payouts. Stock prices can also rise when a firm repurchases its shares. Share repurchases reduce the number of shares outstanding, increasing each remaining share's claim on earnings. If shares are repurchased in lieu of dividends, the per share value (the price) increases.
* A Historical Perspective
Viewed over the recorded history of dividend yields, the recent decline appears to be part of a longer-term trend. Since 1945, the dividend yield has averaged 4.1 percent, more than a full percentage point below its 1871-1945 average. This downward shift is mirrored by the decline in the average dividend payout, which is the ratio of dividends to earnings (see figure 2). The postwar dividend payout was lower because corporate managers retained a greater share of earnings and reinvested them for shareholders.
These retained earnings seem to have been well invested. Table 1 shows that the decline in the dividend yield was more than offset by increased growth in earnings per share (all rates adjusted for inflation). Greater earnings growth permitted greater dividend growth, and this was reflected in higher stock appreciation. Indeed, the postwar increase in the annual rate of stock appreciation more than offset the decline...