Relating Company Fundamentals To The Dividend Discount Model

(I originally posted the following article on The DIV-Net on July 6, 2008.)

Before I describe how to apply the Dividend Discount Model (DDM) to other fundamental company factors like, price to earnings, price to book and return on equity, following is a brief overview of the DDM.

The usefulness of valuing a stock using the Dividend Discount Model is the fact the formula provides an investor a price he/she can expect to receive from the specific stock investment. The investor receives all dividends on an ongoing basis plus the value of the stock when it is sold. In order to value the shares using the DDM, an investor calculates the present value of all the future cash flows. The constant DDM formula is:

The DDM can be used to relate the value of a stock to a company's fundamentals.

Price Earnings Ratio

To get to the P/E or price to earnings ratio, both sides of the constant DDM equation need to be divided by earnings per share. The resulting formula is:

Then looking at the above formula, an investor can tell:

• increase the dividend payout then the P/E increases
• increase the required rate of return, r, the P/E decreases
• increase the growth rate, g, the P/E increases.
  

Required Rate of Return

As noted below, the DDM formula can be rearranged so an investor can ascertain that the required rate of return, r, is comprised of the dividend yield and the rate of growth.

Price of a Stock

Finding the relationship between price of a stock to the book value, return on equity, required rate of return, growth rate and dividend payout ratio involves rearranging the DDM formula as follows:

If B₀ is the current book value and ROE is return on equity, one knows:

E₀=(B₀)(ROE₀) since ROE₀=E₀/B₀.

Therefore,

As a result, the price of a stock, P₀, is related to:

• book value--------------->increase B₀ results in increase in P₀
• ROE--------------------->increase ROE results in an increase in P₀
• dividend yield-----------> increase D₀/E₀ results in increase in P₀
• expected growth rate---->increase g results in an increase in P₀
• required rate of return--->increase r results in a decrease in P₀

Price to Book

Finding the relationship of fundamental company characteristics to a company's price to book ratio simply involves dividing both sides of the above equation by B₀.

Using the above formula then, an investor can determine:

• increase in ROE₀ increases P₀/B₀
• increase in D₀/E₀ increases P₀/B₀
• Increase in g increases P₀/B₀
• Increase in r decreases P₀/B₀.

In the end, using the dividend discount model provides more information than taking the future cash flows from a stock investment and discounting them back to the present via a present value calculation. Delving underneath the formula can provide insight into a company's future prospects if an investor can determine the fundamental company factors that may or may not improve in the future.

Pamela Peterson Drake, Ph.D., CFA of James Madison University has a nice site containing investment information on topics such as portfolio theory and fundamental analysis, just to name a few. Once on the site, click on the "modules" tab.

Source:

Investing in stocks (pdf)
By: Pamela Peterson Drake, Ph.D., CFA
http://peregrin.jmu.edu/~drakepp/investments/modules/module8.pdf

Historical Perspective on Financials Price to Book Ratio

Argus Research recently detailed the price to book ratio for the S&P Financials Index. The chart graphs the P/B ratio over the past 30-years. Argus notes:

"...The index now trades at about 1.3-times its reported book value, down from more than 2-times just last year and more than 3-times when the tech bubble burst several years ago. Granted, this credit cycle is different, and book value is difficult to measure because banks are still holding enormous amounts of difficult-to-value securities on their books. Financial stock bears note that once goodwill and other intangibles are removed from banks’ reported equity, their so-called “tangible” book values are much lower. As a result, these banks are still somewhat pricey on the basis of price to tangible book value. We remain cautious about major banks that still face losses on actual mortgage assets, not just on securities. But we think that the stocks of the major securities firms are looking attractive for those with a tolerance for risk. We believe that the Fed’s move to open the discount window to these companies, along with its decision to accept nonagency mortgage-backed securities as collateral in exchange for Treasuries, should calm the trading markets with time."

(click on chart for larger image)

Source:
Are Financials Nearing a Bottom? ($)
Argus Research
March 20, 2008
http://www.argusresearch.com/

Financial Stocks' Price To Book Ratio Sees Further Decline

The price to book ratio for the S&P 500 financial sector is down to 1.2 versus a price to book of 1.3 in March earlier this year. Argus Research notes:

The S&P 500 Financials index is close to the bottom reached in March 2003, coincidentally about the same time that the broader S&P 500 hit its own bear market low. This time, however, the S&P 500 is less than 15% from its 2007 peak while the Financials are down by nearly 40%. Probably more revealing is that the Financials index now trades for just 1.2-times reported book value, the lowest level since the last major credit crisis in the early 1990’s. At these levels, we’d be ready to sound the ‘all-clear’ signal if not for the fact that we believe that analysts as a group are still too optimistic about bank earnings over the next few quarters. Our 2008 estimates are below the consensus for many of the banks that we follow. We expect a busy second-quarter pre-announcement period for the banks over the next few weeks which may start to finally dampen expectations for 2008.

(click on chart for larger image)

Source:

Financials: Where’s the Bottom? ($)
Argus Research Company
June 16, 2008
http://www.argusresearch.com/

A Piotroski Low Price To Book Stock: Highway Holdings Ltd.

One of the American Association of Individual Investors' better performing stock screens over the long run is the Piotroski Price to Book Screen.

Of late the number of companies passing the screen's criteria has been slim to none. The criteria of the screen are:

• The price-to-book ratio ranks in the lowest 20% of the entire Stock Investor AAII database.

• The stock does not trade on the over-the-counter exchange.

• The return on assets for the last fiscal year (Y1) is positive.

• Cash from operations for the last fiscal year (Y1) is positive.

• The return on assets ratio for the last fiscal year (Y1) is greater than the return on assets ratio for the fiscal year two years ago (Y2).

• Cash from operations for the last fiscal year (Y1) is greater than income after taxes for the last fiscal year (Y1).

• The long-term debt to assets ratio for the last fiscal year (Y1) is less than the long-term debt to assets ratio for the fiscal year two years ago (Y2).

• The current ratio for the last fiscal year (Y1) is greater than the current ratio for the fiscal year two years ago (Y2).

• The average shares outstanding for the last fiscal year (Y1) is less than or equal to the average number of shares outstanding for the fiscal year two years ago (Y2).

• The gross margin for the last fiscal year (Y1) is greater than the gross margin for the fiscal year two years ago (Y2)

• The asset turnover for the last fiscal year (Y1) is greater than the asset turnover for the fiscal year two years ago (Y2).

Currently, only one company out of AAII's database of companies passes the screening criteria. The company is a Hong Kong based company, Highway Holdings Ltd. (HIHO) and trades on the NasdaqCM exchange.

Investors are highly encouraged to fully research any company mentioned before purchasing. In the case of HIHO, it is a small company trading at a stock price below $5 per share. The stock's market capitalization is $6.1 million. These below $5 stocks are typically very volatile investments.

Book Review: Why Are We So Clueless About The Stock Market?

Although I normally do not write book reviews, I agreed to read and review Mariusz Skonieczny's book, Why Are We So Clueless About The Stock Market. Since I would have a few days off around the holidays and the new year, I suppose he made the ask to review the book at an opportune time.

I believe this book is best suited for new, or somewhat new, investors in the stock market. Mariusz does a nice job leading his readers from the beginning or inception of a stock, a company's capital structure and through the time one should consider selling a stock. The book includes a chapter on the economy including a brief discussion on the economic cycle. Mariusz's investment style seems more of a contrarian or value one. He rhetorically ask a couple of questions,

• "When is it best to own a great company--in good times or bad times?"
• "When is one more likely to buy a great company at a reasonable price--in good times or bad times?"

Both are important questions investors need to answer as they buy and evaluate stocks. He does provide answers to the questions in his book.

Buying stocks is not too different from buying real estate. That is, one makes money in real estate not when they sell it, but when they buy it. In other words, what one makes is based on how much they paid for it. Real estate investors have been finding that out over the last year to year and a half. So I digressed.

The book covers topics on valuing stocks based on the dividend discount model. Additionally, he shows how company leverage can add value to a company's earnings. He shows how the value that is created (or not created) is based on the financing cost and the company's return on equity or ROE. In the chapter on "Basic Capital Structure" he provides investors with a way to evaluate a company's earnings growth and whether reinvested earnings are being reinvested "efficiently" as he states.

And finally, beyond the financial numbers, he discusses what comprises a good business. Does the company have a "wide moat" around its products and market. If so, this type of company tends to have higher ROEs and thus potentially higher sustainable returns.

At the end of the book Mariusz provides several case studies or real examples that utilize the topics he covers in his book in order to evaluate specific companies.

In conclusion, I found the book an easy read that was not mired in technical details. Having said this, Mariusz provides his readers with spreadsheets useful in valuing a company's stock. Additionally, I do believe this book will provide its readers with a good starting foundation upon which to build their investment knowledge.

Financial Savings Targets

A key aspect in developing ones investment plan is establishing a financial plan to ensure goals and objectives are being achieved on an ongoing basis. An important component of the plan is the development of specific asset value targets to be achieved on an annual basis.

An article recently published in the Journal of Financial Planning, Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement describes a process to determine what level of investment assets may be required in order to retire in comfort.

The article contains the following executive summary:

• "Investors commonly use stock ratios such as the price to earnings, price to book, and dividend yield to assess the financial health of a company because the ratios concisely benchmark a company's financial status.

• Clients and their financial advisors have no comparable ratios that would allow investors to conduct a similar analysis of their personal financial circumstances. This article establishes a set of personal financial ratios that individuals can use to analyze their financial standing. Just as stock ratios are primarily based on a company's earnings, the personal financial ratios are based on an individual's income. There are three ratios: savings to income, debt to income, and savings rate to income.

• The ratios are derived from a series of assumptions including household budgets, post-retirement income replacement, rates of return, and retirement distribution rates.

• The ratios are designed to serve as a road map so that investors can compare their individual ratios against the benchmarks to determine whether they are on track to retire by age 65. The ratios serve as a practical tool for advisors to help convey to their clients the fundamental relationship between one's income, debt, and savings rate, and how those relationships must change over time."

The article concludes by stating, "...ratios also provide households with a practical tool for analyzing their personal finances and the progress they are making toward financial independence." The article provides a process an investor can go through in determining appropriate levels of retirement savings needed at various stages in their lifecycle.

Source:
Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement
By: Charles J. Farrell, J.D., LL.M.
January, 2006
http://www.fpanet.org/journal/articles/2006_Issues/jfp0106-art6.cfm

Don't Overreach For Dividend Yield

(I originally posted this article on The DIV-Net website on November 16, 2008)

The recent decline in equity prices and near record low interest rates, have enticed stock investors to focus on higher yielding dividend paying stocks. One must keep in mind though, a stock's dividend yield is not the same as comparing yields on certificates of deposit.

"After all, if one invests primarily for current income, it might seem logical that stocks with the highest yields would be best. The popularity of the “Dogs of the Dow” approach would seem to support that assumption. However, the Dow Dogs approach is designed to beat major averages through price appreciation; the high yield under that approach is merely an indicator of possible undervaluation."

The stocks that trade at higher yields tend to be the ones that are at the highest risk of a dividend cut. Ideally, stocks with lower yields and the ones that grow the dividend on a regular basis tend to be the type of stock that outperforms the market over the long run.

This year's performance of the high dividend yield approach of the Dogs of the Dow strategy offers some evidence that a high yield approach does not always mean higher total return. The year to date return as of November 21, 2008 for the Dow Dogs equals -50.0% versus the return on the Dow Jones Index of -39.3%.

The dividend-discount model is based on the assumption that dividends ultimately drive share price. If a firm doubles its dividend over a certain time, its stock price should also double if interest rates do not change.

Thus, the percentage rate of dividend growth drives and equals the expected rate of increase in share price. From that equivalence, we can derive this formula for expected percentage total return:

Expected Total Return =
Expected Dividend Growth Rate +
Current Dividend Yield

One event that is occurring with companies and the overall economy is the process of deleveraging. In this environment investors should likely look to invest in those firms that have lower debt levels. The risk of only investing in low debt level firms is when the market/economy improves, leverage can actually enhance a company's earnings, resulting in better performance in a somewhat leveraged company. For those interested, this leverage factor enhances ROE through the equity multiplier as detailed in the Dupont Model.

A few financial measures useful for dividend oriented investors to review are:

• Common shareholder’s equity as a percentage of total capital
• Short-term debt as a percentage of total debt (or of total capital)
• Dividend payout ratio
• Dividend growth rate
• Frequency of dividend increases
  
• Price-to-book-value ratio

There is no perfect model to use when evaluating dividend paying firms. However, watching the trend in the above factors, like payout ratio, frequency of dividend increase, etc., can provide clues into when a company might be anticipating earnings weakness in the future. Don't simply get trapped buying the highest yielding stocks, then suffer through a dividend cut. Company's that cut their dividend tend to see a contraction in the company's stock price.

Source:

Equity Income Investing: Beware of Yield Overreaching ($)
AAII Journal
By: Donald Cassidy
May 1999
http://www.aaii.com/includes/DisplayArticle.cfm?Article_Id=822

An Increasing Dividend Payout Ratio Is A Positive Indicator For The Market

Admittedly, in an equity market run investors are currently experiencing, i.e., the second longest run without a 20% pullback, a common theme that continues to seep into ones thinking, including mine, is when is the market going to experience a bear market correction of 20% or more. Even a double digit pullback is a scarcity as the below chart of the S&P 500 Index shows. The last double digit pullback occurred in February of 2016.

Continue reading >>>

Investing Carnival #14

The state of the market seems to have dictated many of the topics in this week's carnival. As the below posts note, many provide advice on how to handle this market volatility.

DIVIDEND INVESTING

The Dividend Guy Blog notes "there are 4 crucial factors a dividend investor must consider," in the post The Four Most Important Metrics When Evaluating Dividend Stocks.

STOCK ANALYSIS

Dividends 4 Life presents Stock Analysis: Pitney Bowes Inc. (PBI) noting, "Pitney Bowes Inc. is the world's largest maker of mailing systems, also provides production and document management equipment and facilities management services. Linked here is a detailed stock analysis and commentary."

Central Europe & Russia Fund Inc. (CEE) Analysis - Revisited posted at One Family's Blog, notes, "An analysis of CEE, a closed-end exchange traded fund (ETF) focused on Central Europe & Russia trading at a double-digit discount to NAV."

INVESTING

Your Finish Rich Plan presents Understanding Stock Market Volatility: Perception vs. Reality noting, "The stock market can be very volatile in the short-run, but when considering longer time frames, it's not nearly as volatile and is actually quite predictable"

Triaging My Way To Financial Success presents Capitulation Chaos: advising there is "A valuable insight into how to best position yourself for market volatility from a fellow value and dividend investor"

Invest In India presents Are you disappointed with your mutual fund investments? noting "2008 has been tough on investors. This holds especially true for first-time investors. After having seen the markets surge to record highs, the downturn has certainly caught several investors off-guard."

MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy notes in the post, The Problem with Investing in Banks, that "Magic Formula investors have luckily been spared from the calamity in financial stocks over the past year. But even in the best of times, banking is a risky industry that is difficult to properly value, and should be avoided by most individual investors."

FIRE Finance writes about some of the risk factors that impact the market in the post, Investment Risks at a Glance.

The Financial Blogger notes in the post, Is the apocalypse among us?, that "The US market is going down and major companies are following the trend. What is going on?"

The Simple Dollar's post Using TreasuryDirect for Conservative Investing provides, "A basic description of how TreasuryDirect works and what you can invest in there."

The Iconoclast Investor offers insight into the recent market volatility, 10 Observations About This Financial Storm.

My Simple Trading System blog highlights two emotional factors that influence investors at the post, Lehman, Merril Lynch, and AIG Lead to The "Unbubble".

In Trader's Narrative's post, TED Spread: Going Where No Spread Has Gone Before it is noted, "The TED spread is one of the most basic gauges of fear in the financial markets. TED stands for Treasury Eurodollar because originally it was calculated by taking the US 3 month treasury bill and subtracting it by the 3 month Eurodollar contract rate. Today the spread is calculated by taking the difference between the 3 month US T-bill rate and the 3 month LIBOR rate."

The Digerati Life's post provides insight on "What should an investor do during a turbulent stock market period?" at Best Places For Your Money When The Stock Market Tanks

How to Protect Yourself Against the Economic Crisis posted at The Smarter Wallet, provides some timely investment advice during this volatile market period.

Doing Nothing Can Be a Strategic Response to a Market Crash posted at Tough Money Love » Hard Truth and Tough Love for Money Problems and Personal Finance, saying, "When the market is in crisis, doing nothing can be a strategic response"

Some books and DVDs for a tough market at Gift Ideas for Stock Market Junkies posted at The Investor's Journal

VALUE INVESTING

Barel Karsan writes about the Canadian furniture manufacturer Amisco and its cheap price to book ratio in the post, Amisco: Liquidation Value.

WEALTH ACCUMULATION

Investment Internals notes at the post, Money lessons to kid, that one should "teach your kid about money and how to deal with money at various ages and let them achieve financial wisdom when they start earning."

ALTERNATIVE INVESTMENTS

Passive Family Income provides a review of covered call transactions at Wachovia Covered Call Contracts.

REAL ESTATE

Is It Possible that Housing Prices May Not Stabilize Until 2014? posted at Fiscal Zen.


That concludes the fourteenth carnival edition. Submit your blog article to the next edition of Investing Carnival using our carnival submission form. Past posts and future hosts can be found on The DIV-Net's blog carnival index page.

Investing Carnival For November 25, 2008: Ready For A Bounce?

Welcome to the November 25, 2008 edition of the investing carnival. There were a large number of submissions this week and I had to leave a few out in order to keep the carnival at a reasonable length. The articles were submitted over the course of last week. The tone of many of these articles seem to be predictive of the market bounce experienced the past two trading days.

Dividend Investing

Top dividend stocks with reasonable payout ratios (MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy)

Stock Analysis

A potentially huge reward with an asset play in Value Vision Media Inc (VVTV). (Old School Value)

An in depth analysis of Sysco Corp (SYY). (Dividends 4 Life)

Even Berkshire-Hathaway's (BRK/A) stock is suffering in this market. (Intelligent Speculator)

Is Baidu.com's recent decline a buying opportunity? (Intelligent Speculator)

Screening the Forbes Best Small Companies list for investment opportunities. (Old School Value)

Can Citigroup regain its footing? (Smart Money).

Smith & Wesson & Ruger-are they shooting blanks? (Tough Money Love » Hard Truth and Tough Love for Money Problems and Personal Finance)

The losers in the Volkswagen and Porsche merger battle. (My Simple Trading System)

Investing

A review of the book Investing for Dummies. Maybe a good read for all investors? (Living Almost Large)

Insight into performing fundamental stock research. (Finance-Information)

Financial issues impacting individuals beyond just the stock market. (KCLau's Money Tips)

A primer on the Price to Earnings ratio or P/E. (Investing School)

10 better investments than the market. (Learn The Stock Market And How to Trade)

More bold predictions from Jim Rogers. (Subprime Blogger)

Does one quarter of negative GDP growth equal a recession? (The Political and Financial Markets Commentator)

Inflation protection strategies for ones portfolio. (FIRE Finance)

Tips on staying afloat in this market. (Beating The Stock Market)

Reduce fund expenses with Vanguard Admiral shares. (Free Money Finance)

Investments for a depression like economy. (Zignals blog)

Advice on getting your investments back on track. (The Iconoclast Investor)

Investing through TreasuryDirect. (Wealth Junkies)

Is your 401(k) account safe. (The Digerati Life)

A review of the best asset allocation on a historical basis. (Ripe Trade)

When analyzing a company, read the footnotes in the financial statement. (Value Investing and Entrepreneurship by Qovax)

The importance of choosing the right asset allocation. (The Sun’s Financial Diary)

Value Investing

Obama's energy plan may benefit these stocks. (The Green Investing Blog)

Alternative Investments

Don't fall for stock option "get rich quick" schemes. (Michael James on Money)

Wealth Accumulation

10 steps to building ones wealth. (Money Blue Book)

Tips on saving money by reducing household expenses. (Money Blog)

If one consolidates their debt, they need to cut their expenses too. (Finance Tips 101)

That concludes this edition. Submit your blog article to the next edition of investing carnival using the carnival submission form. Past posts and future hosts can be found on our blog carnival index page.

* image at beginning of post courtesy of CNN Money

Readings for the New Year

Following are several links to articles discussing the relationship of dividend growth to earnings growth.

• Surprise! Higher Dividends = Higher Earnings Growth (pdf), by Robert D Arnott and Clifford S. Asness.

• As noted below, the article concludes future earnings growth is highest for the firms that have high current payout ratios. The article does offer the caution that an investor needs to determine if a company with a high payout ratio can maintain the dividend at the current high rate.
  

• "We investigate whether dividend policy, as observed in the payout ratio of the U.S. equity market portfolio, forecasts future aggregate earnings growth. The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors, such as simple mean reversion in earnings. Our evidence thus contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is consistent with anecdotal tales about managers signaling their earnings expectations through dividends or engaging, at times, in inefficient empire building. Our findings offer a challenge to market observers who see the low dividend payouts of recent times as a sign of strong future earnings to come."
  

• Estimating the Long-Term Return on Stocks by John P. Hussman, Ph. D.

• The article provides an analysis similar to the yield to maturity (YTM) calculation for bonds. The Hussman article contains a formula an investor can use to determine YTM for stock investments.

  "...For stocks, the "yield-to-maturity" comes from two components: income plus capital gain. The income component is simply the dividend yield. Assume initially that the dividend yield is held constant over time...If the dividend yield (Dividend/Price) is constant, then by definition, prices must grow at exactly the same rate as dividends grow. By definition, when the dividend yield is unchanged between the date you buy stocks and the date you sell them, your total return equals the dividend yield (income) plus the growth rate of dividends (capital gain)."

• High Dividend Stocks: Bonds with Price Appreciation? This article is Chapter 2 of the book Investment Fables by Aswath Damodaran, Ph. D., a professor at New York University.
  

Dividend Payers Underperformed Non Payers In 2014 And Equal Weighted Risk

The chase for yield in 2014 did not lead to the dividend payers in the S&P 500 Index to outperform the non-payers. As the below table shows, the average return of the payers, 14.99%, fell just short of the average return of the non-payers that generated a return of 15.44%. The average return for both categories though did beat the cap weighted return of the overall S&P 500 Index.

From The Blog of HORAN Capital Advisors

Source: S&P Dow Jones Indices

Jim Paulsen, Ph.D., Chief Investment Strategist at Wells Capital Management, recently wrote a research article on valuation of the S&P 500 Index. In his report, Median NYSE Price/Earnings Multiple at Post-War RECORD, Paulsen notes the median stock in the index trades at a record high valuation at approximately 20 times earnings. The report notes historically, when the market traded at high valuations, investors could find certain sectors not trading at high valuations. An example noted in the report,

"The 2000 stock market was characterized by a significant overvaluation among the fifth to 20th P/E percentiles while valuations in most of the rest of the market were either average or below average. Today, the entire stock market (low P/E stocks to high P/E stocks) appears highly valued relative to history. Similarly, Chart 8 [in the report] illustrates that today’s valuation profile is also much more broadly extended than it was at the top of the 1970’s Nifty Fifty era."

According to Paulsen, an implication of this high median valuation could be cap weighted indexing for the U.S. market will generate better returns than an equal weighted approach. Additionally, international market valuations suggest opportunities may exist in those markets vis-à-vis the U.S. Several of his comments in the report around this topic,

• "First, the valuations of U.S. stocks are much higher than widely perceived or as suggested by the valuation of the popular S&P 500 Index. Moreover, today’s valuation extreme is not limited only to a subset of stock market sectors but rather is very widespread whereby nearly all P/E multiple percentiles are at or close to post-war records."

• "Finally, the current valuation extreme is not the result of poor performance from a single valuation metric. U.S. stocks are broadly and richly priced compared to earnings, cash flows, and book values. Second, because valuation dispersion is relatively low today, there are not many areas to hide from overvaluation. In 1973 or 2000, investors could reduce extraordinary valuation risk by simply diversifying away from the Nifty Fifty or new era tech stocks. Today, because values are both high and tight, lessening valuation risk may not be possible except by allocating away from U.S. stocks."

• "Today, even though a larger portion of the overall stock market is aggressively priced, it has not garnered nearly as much attention. A concentrated valuation extreme tends to loudly announce itself whereas a broad-based valuation extreme seems more stealth and, therefore, perhaps more dangerous."

QE's Influence On Equity Prices

One debatable issue with the Fed's quantitative easing (QE) program is whether or not the QE activity has an impact on equity prices. In a recent McKinsey & Company study, QE and ultra-low interest rates: Distributional effects and risks, McKinsey concludes,

"We found little evidence that ultra-low interest rates have boosted equity markets. We cannot discern a large-scale shift into equities as part of a search for yield by investors, and price-earnings ratios and price-book ratios in stock markets are no higher than long-term averages. Although stock prices do react to announcements by central banks, these are transitory effects that do not persist."

If a picture is worth a thousand words, then the below chart seems to suggest QE has positively influenced equity prices.

From The Blog of HORAN Capital Advisors

Source: McClellan Financial Publications

If QE has had a positive impact on equity prices, the next question becomes what happens when the QE program comes to an end. The recent focus has been on the timing of the Fed "tapering" its purchases. Tapering is still QE but simply in a lesser amount; hence, supportive of equity prices if one believes a positive correlation exists.