Value Investing With Dividend-To-Market Ratio
University of Adelaide, Students
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July 12, 2016
The book-to-market ratio (BM) is a noisy metric for value investing because book value is a weak indicator of intrinsic value. Using the dividend discount model of Miller and Modigliani (1961), this paper proposes an alternative metric for value investing: the dividend-to-market ratio (DM), where dividend is measured as profitability minus investment. Test results show that DM effectively distinguishes between undervalued stocks and overvalued ones, leading to substantial economic gains. Further, DM is a parsimonious, more efficient measure to estimate expected returns than a linear model consisting of BM, profitability and investment. An investor can increase a portfolio’s Sharpe ratio by adding a DM factor rather than a combination of the BM, profitability and investment factors.
Value Investing With Dividend-To-Market Ratio – Introduction
A great deal of academic research has been published on value investing, which suggests buying undervalued stocks and avoiding overvalued ones with respect to their intrinsic value. Evidence on value investing is overwhelmingly dominated by the book-to-market ratio (BM) metric, pioneered by the findings of Rosenberg, Reid, and Lanstein (1985) and Fama and French (1992). However, because book value is a weak indicator of intrinsic value, BM is a noisy metric for value investing1. Specifically, BM does not differentiate between a lowpriced stock with a high intrinsic value and one whose low price is consistent with its low intrinsic value (low expectation of future cash flows). Since the second scenario is more likely in a highly competitive market, BM is rather inefficient in identifying the best value opportunities. A high BM portfolio is heavily populated by stocks that are not undervalued by the market and therefore is sub-optimal for value investing.
Using the dividend discount model of Miller and Modigliani (1961), this paper proposes an alternative metric for value investing: the dividend-to-market ratio (DM):
where dividend is defined as the maximum payable dividend (profitability minus investment), following the notation of Fama and French (2006). Miller and Modigliani (1961) claim that a firm’s value is justified by its expected dividends – the difference between the earning power of the firm’s assets and the reinvestment of earnings required to generate future cash flows. Given estimates of expected dividends and current market value, we can solve the market discount rate on expected dividends (i.e., long-term average expected returns) (see Fama and French 2006 and 2015a). Hence, it is a straightforward choice to use the ratio of expected dividends to market value to estimate the cross-section of market discount rate.
Because expected dividends are a strong indicator of intrinsic value, the dividend-to-market ratio effectively distinguishes between undervalued stocks and overvalued ones. A high (low) DM indicates the firm’s expected future cash flows are currently discounted at a high (low) rate, hence its stocks are in the value (growth) category. If two firms are identical in market valuation but different in dividend, the firm with larger dividend must have a higher market discount rate. Likewise, if two firms are identical in dividend but different in market valuation, the firm with higher market valuation should have a lower market discount rate. Value investors could thus maximize their economic gain per dollar of investment by constructing a high DM portfolio, holding stocks with strong fundamentals at moderate prices, as well as stocks with average fundamentals at discount prices.
Using portfolios formed by double sorts (3×3) on BM and DM, I find that 30% of high BM stocks have low DM value, indicating that they are low-priced with low intrinsic value. These high-BM and low-DM stocks substantially underperform the market, which directly illustrates that BM is a noisy metric for value investing. Consistent with the prediction of the dividend discount model, value investing with DM leads to substantial economic gains in the sample period July 1963 to December 2013. For zero-cost mimicking factors formed by double sorts (2×3) on size and DM, a $1 factor exposure delivers a cumulative profit of $28.84 for the DM value factor, but the cumulative profit for the BM value factor is only $4.35. The Sharpe ratio improves from 0.39 for the BM value factor to 0.81 for the DM value factor. Thus, DM is superior to BM for value investing from both theoretical justification and empirical regularity.
This paper adds to a growing literature using the dividend discount model of Miller and Modigliani (1961) to enhance estimates of expected stock returns (see Fama and French 2006, 2015a and 2015c, and Aharoni, Grundy, and Zeng 2013, and Novy-Marx 2013). The focus of those papers is to decompose the valuation equation of the dividend discount model into three component variables (BM, profitability and investment) and then combine them linearly to estimate expected returns. My work differs from those papers in one important way: I take an integrated approach using DM alone to estimate expected return. The dividend discount model indicates that DM, the interaction term between expected dividends and market value, provides a closed end solution to expected return. Therefore, the marginal effect of expected dividends on expected return depends on the market value level, whereas the marginal effect of market value on expected return depends on the expected dividend level. A linear combination of BM, profitability and investment cannot substitute for the critical interaction term between expected dividend and market value and, therefore, it is insufficient to provide a clean perspective on expected return.
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