Relationship Between Dividends and Stock Prices

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In financial theory, the value of a stock is closely tied to the expected dividend stream. Consider stocks A and B, such that if you purchase A you reasonably expect dividends of $100 a year for the indefinite future, and if you purchase B you reasonably expect a dividend stream of $200 a year. If the risk is comparable, then you would expect B to have a market value twice that of A.

In empirical fact, there is such a connection, but it is not especially close. Dividends and prices both meander in ways that seem unrelated, but that prove over the long run to be cointegrated.

Cointegration

A 1999 paper by David Power and Ian March, two U.K.-based financial economists, provided empirical support for the theoretical relationship between the expected dividend stream and prices. Working from a data base of 56 large U.K. companies, they found that stock prices and dividends are "cointegrated."

Cointegration is a looser form of statistical connection than straightforward correlation. The usual humorous illustration of cointegration is of a drunk and her puppy. The drunk stumbles about aimlessly, while the dog wanders curiously, chasing interesting smells in the grass. But at periodic intervals, the drunk will remember to call for her dog, and the dog will hasten to her side.

Considerations

It is extremely risky to make investment decisions based upon this relationship, though. In particular, a dividend increase may in some circumstances be a bad sign. It may mean that the company issuing the dividends is making a desperate cosmetic plea to restore confidence in its strength. Lehman Brothers increased its dividend by 13 percent in early 2008, and filed for bankruptcy court protection that September.

Misconceptions

It would be a misconception, too, to presume that a dividend cut is always a bad sign. Ford Motors suspended its dividends in 2006. It also proved to be the only one of the U.S. big three auto companies that survived the financial crisis of 2008 without court-ordered reorganization.

Balance Sheet

At the company's annual meeting in May 2010, the Executive Chairman explained that the company was in no hurry to resume payments. "It's very early days in our recovery," said Bill Ford Jr., "and we still have a lot of debt. And I think the most important thing we can do as a company is to get our balance sheet strengthened and in order."

History

In the century prior to the bear market of the early 1980s in the U.S. stock markets, the market's average dividend yielded 5 percent consistently. But that bear market was a watershed. Since then, dividend yield has fallen dramatically. Between 1983 and 2010 it averaged 2.53 percent, according to a website maintained by financial consultant Doug Short.

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