Dividend-Price Ratio as predictor of Stock prices

Three American professors won the 2013 Nobel Prize in Economic Sciences. One of them is Robert J. Shiller, Professor of Yale University.

His research paper published in Winter 1998 in the Journal of Portfolio Management was the subject of this blog post.

Prof Shiller’s research paper pointed towards valuation ratios are extraordinarily bearish in 1998. He used two valuation ratios: Dividend-Price ratio and Price to Smoothed-Earnings ratio to make that observation.

His research pointed to the fact that Dividend-price ratio forecasts movements in stock price. The stock price has moved to restore ratio to its mean value (ie normal historical level). It is the stock prices and not the dividend in the dividend-price ratio that brings ratio back to its means.

Note: D-P ratio is measured by previous year’s dividend divided by January stock price.

Price to smoothed-earnings ratio can also forecast 10-year growth in stock prices based on Shiller’s research. Smoothed-earnings is average of real earnings for past 10 years.

So two important ratios commonly known as Dividend yield and Price-Earnings ratio are good predictor of stock prices. (Dividend-Price ratio is actually Dividend yield.) If one can determine long-term mean (also called average) for both ratios for companies, then if the ratios deviated extremely from the mean, warning bells should be set off for investors. Buying and selling decisions can be made based on these ratios.

Copyright © 2013, limkimtong for Living Investment

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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