The “Equity premium,” written by Eugene F. Fama and R. French (2002) describes how to estimate equality premium using both dividend and the growth rate of earning to predict the rates of expected capital gain. The equality premium is important in making decisions on portfolio allocation and in estimation of capital gain. The expected market return is estimated using the returns on portfolio of stocks. To estimate the stock return, the dividend and earnings are used along with other evidence to determine if the expected return is higher than the realized average. In this case, the average stock return is the averages dividend yield added to the average capital gained. However, a consideration is made in that some companies may move from dividend to share repurchasing that would have a fundamental change in the total capital gain as the prices of the shares vary.
The earning, even within a specific time vary depending on the changing times. To calculate the equity, the dividend growth model is better than the others since it is simpler in calculation. In addition, it is general and hence can be applied in diverse situations. The valuation model has been applied in various times and the authors find it prudent to advance literature on the same. However, the authors note that the valuation model is valid if the dividend, price and earnings and the price ratios remain stationary. The authors note that the dividend-price and earning price ratios decline from 1950 to 2000 while the cumulative capital gain increase threefold in earnings and dividends. The earnings and dividend growth rates between 1950 and 2000 are mainly unpredictable. Therefore, a decline in price ration emanates from the declined expected returns.
In the first section of the paper, the unconditional annual expected stock return ( Eugene F. Fama and R. French,2002) are analyzed. In this section, a careful analysis of annual expected equity premiums for the period 1872 to 2000 is done. From the table, the authors opine that without availing all details, the CRSP value weight portfolio of AMEX, Nasdag and the NYSE yields average dividend and returns growth estimates near to the S&P estimates for the period after 1925. Since the investment goal is consumption, real returns are relevant and hence, the estimation of expected returns can be calculated in nominal terms. Structural shifts in the preferences can permanently alter the expected returns or growth rates.
One major advantage of estimating the expectation returns using the fundamentals is that the fundamental are less sensitive than the average return in the case of stocks that have been in the market for long. The results on the equity premium from 1872 to 2000 and from1872 to 1950 have a similar expected return. After this period, the expected returns show a diverging trend. For period 1872 to 1950, there is no major reasons to back the dividend growth rate over the average return of the expected stock return. It shows that the 1950 break-year does not have effects whether pushed forward or backwards. Comparing the dividend growth model expected return and the average stock model expected return for 1951 to 2000, the results shows that the former is just half of the later, i.e. 4.74% and 9.2% respectively.
On evaluation of the expected return for the period 1951 to 2000, earnings and dividend growth estimates are precise as opposed to average return. The two periods, 1872 to 1950 and the 1951 to 2000 have almost the same aggressive risk aversion. During the same period, the behavior tends to favor the earnings and the dividend model than the average model. The expected return is higher for the period 1951 to 2000 than 1872 to 1950, as evidence by the Sharpe ratios. Owing to the fact that the unexpected returns for the 1951 to 2000 has the same effects on the three expected return estimates, to explain the differences on the expected returns can be established by considering the future expected dividend and the expected return.
The stock returns fall from 7.18% as at the end of 1951 to 1.22% recorded at the end of 2000. Expected future returns, earning growths, and future dividends drive all the models of valuation. Dividend growth model has an advantage over the earnings growth model in the face of share-repurchasing. It is evidently clear that for the period between 1951 and 2000, the mean stock return is greater than the averages income return as recorded in on book equity. The unconditional expected equity premium for the last 50 years is most likely below the premium realized (Eugene F. Fama and R. French, 2002).
Work cited
Eugene F. Fama and R. French. Premium equity. 2000.The Journal of finance. Accessed from http://www.jstor.org/page/info/about/policies/terms.jsp on November 3, 2014.
