Explaining the Variance of Price–Dividend Ratios

Abstract

The author reports a bound on the variance of price-dividend ratios and a decomposition of their variance into terms that reflect changes in dividend growth and discount rates. The specification is not restrictive. The test statistics do not require construction of ex post present values; instead, they are restrictions on means, variances, and covariances of price-dividend ratios, dividend growth, and discount rates. He considers implications for the mean price-dividend ratio, and he evaluates whether a low mean discount rate can rationalize the mean and variance of price-dividend ratios. The results do not indicate any striking rejections of present-value models. However, the bulk of the variance of price-dividend ratios must be accounted for by changing forecasts of discount rates, and discount rates must possess some unusual characteristics. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.