The role of dividends in valuation models used by analysts and fund managers

Abstract

The value of a share is given by the dividend discount model as a simple function of future dividends; but the actual determination of the share price is rarely based upon the direct estimation of these future dividends. A ranking of the valuation models used by analysts and fund managers shows a preference for ‘unsophisticated’ valuation using, for example, the dividend yield rather than the dividend discount model. This finding is shown to depend upon the practical difficulty of using currently-available information to forecast future cash flows. This difficulty limits the quantitative basis of valuations to short forecast horizons, while the subjective, qualitative estimation of terminal value assumes great importance. Crucially, both analysts and fund managers use their own assessment of management quality to underpin the estimation of terminal value, on the basis that superior quality causes outperformance and that, whereas management quality can be assessed now, future performance itself is unobservable. Linked with this and with information asymmetry, valuation is a dynamic, company-specific process, focused on personal communication with management and embodying ongoing signalling and implicit contracting, using both dividends and other variables. This method of valuation causes formal valuation models such as the dividend yield to play only a limited role. They offer a benchmark of relative price differences, which serves as a basis from which to conduct subjective, company-specific analysis and to make investment decisions; but valuation models are not used exclusively, in themselves, to value shares.