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Why The Price Dividend Ratio Is Better Than PE Ratio at Trader’s Narrative





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price earnings ratio historical chartThe PE ratio needs no introduction. For a very long term chart of the ratio, click on the image to the left. The source of the chart is the NY Times with a helping hand from the economist, Robert Shiller. I was surprised to see that we were trading at a higher PE ratio as early as last year, than the top in 1929!

The graph above is based on the average earnings for the preceding 5 years. This chart is more short term, based on the rolling 4 quarters of earnings:

price earnings ratio rolling annual chart

Why Use the Price Dividend Ratio?
I’m not sure where I first learned about this ratio. But Stan Weinstein really made it stand out for me as a very important measure of market valuation in his book: “Secrets For Profiting in Bull and Bear Markets” The power of this ratio comes from the fact that unlike earnings, dividends can not be “massaged” by creative accounting. There are no “EBIT” dividends. They are completely immune from accounting shenanigans. They are either declared and paid in cash or they aren’t.

Also dividends are free from the year to year shocks such as “write-offs” which can affect earnings. Most companies treat their dividends with what you might say approaches reverence because dividends send such a clear and strong signal about their financial strength.

I’m loathe to dip into the fundamental analysis toolbox but from time to time, when the situation warrants, I do. But for the reasons above, I prefer to use the price dividend ratio instead of the much more popular price earnings ratio.

Basically, the ratio tells you how much you have to pay for $1 of dividends. So in a way it can be equated to the “yield” coupon of the stock market. Or the inverse dividend yield of the stock market. And because of that, it has some correlation to the interest rate. So when interest rates are high, usually the dividend yield is also high.

Here is a very long term chart of the S&P 500 Index. I’ve added two data points, one for where we were this time last year and one for now:

sp500 price dividend ratio long term chart
Source: Federal Reserve Bank of San Francisco

Dow Jones Price Dividend Ratio
A year ago, when the Dow was at ~14200, the price dividend ratio was 49. Meaning you would have had to pay almost $50 to get $1 of dividends a year. It also corresponds very closely to the S&P 500’s price dividend ratio (above).

As of now, however, the Dow’s price dividend is a more reasonable 26. This is because of two things. First, and most obviously, the Dow has come down a lot, but also importantly, dividends have increased a healthy 11.7% from a year ago.

As you can see from this long term chart of the Dow’s price dividend ratio, we are right around the long term average for this ratio:

price dividend ratio chart john bogle on mutual funds
Source: John Bogle on Mutual Funds

As we’ve all noticed in the past few days, the market has the ability to reach maximum levels and then to keep pushing into new territory (I’m looking at you VIX). So just because we are now at a much more “normal” price dividend level doesn’t mean that it can’t go lower. For example, here’s a really scary picture of what might/could happen.

Having said that, I’m glad to see this fundamental ratio not clash with other technical indicators which are pointing to a potential market bottom.

The charts above are long term but do not show the most recent years, so if you know of a more up to date price dividend ratio, I’d love to see it. Or if you have access to a platform like Bloomberg, where you can look it up, send me a screengrab. I’m sure the most recent data holds some insight.

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16 Responses to “Why The Price Dividend Ratio Is Better Than PE Ratio”  

  1. 1 Dividends Anonymous

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    Very informative analysis TN

    I’ll be sure to pass it along to my readers!

  2. 2 market folly

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    yea good points here. i hadn’t looked at this ratio in forever, thanks for the reminder!

  3. 3 Russ Abbott

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    I’m surprised that as of Friday the S&P PE ratio based on trailing 4 quarters was as high as 17.2. Although not outrageously high, it’s not cheap either. And since one can reasonably expect earning to decline in the coming year, that would suggest we are not undervalued. The correction hasn’t gone far enough?

  4. 4 The Second Last Samurai

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    When earning goes down, expect those companies cut the dividends.

  5. 5 Rob Weigand

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    I’m not sure that a long time series of D/P ratios provides as much of an “apples-to-apples” comparison as a long time series of P/E ratios, as companies have dramatically altered their attitudes about paying dividends since the 1990s. This means that low D/P ratios don’t measure overvaluation in the same way that they did 1950-1990 (and vice versa for high D/P’s). Another point, since you quote Shiller — his work (with John Campbell) forcefully emphasizes that the most informative P/E series is the one with 10-year smoothed earnings in the denominator, rather than the one you plot, with 1-year trailing earnings. I enjoy your blog, keep writing. http://marketblog.wordpress.com.

  6. 6 Babak

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    Rob, you make good points. However, re the difference in approaches to dividends over time, the same thing could be said of earnings. In the old days they never used as much financial engineering as they do today to get earnings just right. They also didn’t have “whisper” numbers, EBIT, etc. Time series comparisons have all sorts of issues but that goes across the board.

  7. 7 Rob Weigand

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    I have no doubt that if an executive from 50-60 years ago saw how the earnings management game is played today they would be appalled. Nonetheless, I still maintain that the profound shift in companies’ willingness to pay dividends accounts for much of the decline in the market D/P ratio. Notice the disconnect between the market D/P and P/E even today. After Tuesday’s 9% decline in the S&P 500, the market P/E indicates that stocks are priced to deliver average long-term returns again (meaning that if you bought in at today’s levels, 20 years from now you probably will have earned close to 10% per year). But the current market D/P suggests stocks are still profoundly overvalued, which — at least to me — does not make sense. Thanks for your reply.

  8. 8 Mike

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    Ok guys this is great information. I think what Rob is saying is lets factor growth into this since growth = future increased dividends or an increase in stock price (typically).

    So where can we get this data integrated with growth graph it and look at the dow and maybe any stock (and do it fast).

    Great work!

  9. 9 Rob Weigand

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    Robert Shiller of Yale makes the data available for free on his website: http://www.econ.yale.edu/~shiller/data.htm. You can download everything you need in one Excel file (monthly values).

  10. 10 MrColonelMustard

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    A couple of thoughts for a first-timer to this blog (and blogging):

    Have you considered inflation-adjusted the P/E Ratios and D/P Ratios? At my glance, the effect seems intuitive: the Look-Through Earnings (average 7.7%, let’s say) are higher than the Dividend Yields (4.1?) If the average inflation rate was 3.0% and we subtracted that from the Look-Through Earnings and Dividend Yields, then the standard deviations would decrease for each (right?), more so for the Dividend Yields. Wouldn’t that imply easier predictability?

    Also, I am wondering what percentage of lower P/Es and/or higher dividends are caused by inflation expectations. Since such a number (inflation expectation) isn’t available, simply charting it historically might be the best one can do. I’d like to get my hands on some historical DJIA or S&P dividend yield data, nominal and inflation-adjusted. As I gain information, I’m happy to share. I have plenty of 10-year data, but I’d like 1950 to 2000 at least or 1900 to 2000. I try to dig through all the links here and associated files and articles.

    Good stuff!

    MrColonelMustard

  11. 11 Rob Weigand

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    Notice that P/E ratios are already expressed in real terms. When nominal stock prices (P) are divided by nominal earnings (E) the effect of inflation in the ratio’s numerator and denominator cancels out: P(1+r)/E(1+r)=P/E. Therefore, an E/P “earnings yield” is already a real number. Same for nominal dividends (D) divided by nominal prices (P). This is an often-overlooked oversimplification with the so-called “Fed Model,” which compares the stock market’s average earnings yield (E/P) to the 10-year T-note yield (Y) to determine whether equities are relatively cheap or expensive. The E/P ratio is a real number being compared to a nominal number (Y). Also: the data you’re interested in obtaining is available from Shiller; see the URL provided in my October 16 reply above.

  12. 12 Babak

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    Thanks Prof. Weigand, can’t believe I overlooked that.

  13. 13 MrColonelMustard

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    Sorry, I fell of the edge of the planet. Prof Weigand, that math seems unarguable (and equally applicable to price/dividend ratios). I’m curious what I’m missing intuitively. I don’t recall reading much about this in articles or books. (Do you have any suggested books for how inflation affects such decisions?)

    This seems particularly relevant and missing in articles I’ve read about the Equity Premium and long-term real bond vs stock returns. (Nothing particular comes to mind. I need to get another copy of The Intelligent Investor. I thought Graham discussed it.)

    Is there a basic assumption being made that stocks are inflation resistant? (because price & earnings raise or fall with the CPI) Obviously, unanticipated inflation causes financial stress, but I could foresee an argument that strips that out.

  14. 14 Rob Weigand

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    Best I can recommend is my Journal of Portfolio Management paper (summer 2007) and Journal of Investing paper (spring 2008). Bibliographies have many references on the equity premium and how market valuation ratios can be used to forecast long-term stock market performance. You can email me for copies if you like: rob.weigand@washburn.edu.

  15. 15 systemBuilder

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    A company can’t lie about a Dividend. They either pay it or they don’t. If they try to borrow money and pay out too many dividends, they go bankrupt and the bond investors forclose upon the company.

    You can say that companies have “Changes their attitudes about Dividends”. Nothing could be further from the truth. In truth, Investors have become stupid and intoxicated with stocks as investments. They are being stupid when they don’t demand dividends !!

    Remember that for 20 years after the 1929 crash, stocks ALWAYS paid a higher dividend than bonds because you could lose your principal !! Well, that day will come again, in 2010 or 2011 !!

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