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Why the Price Dividend Ratio Is Better Than the P/E Ratio

by: Babak October 13, 2008 | about stocks: DIA / QQQQ / SPY    

Babak

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price earnings ratio historical chartThe PE ratio needs no introduction. For a very long term chart of the ratio, click on the image to the left. The source of the chart is the NY Times with a helping hand from the economist, Robert Shiller. I was surprised to see that we were trading at a higher PE ratio as early as last year, than the top in 1929!

The graph above is based on the average earnings for the preceding 5 years. This chart is more short term, based on the rolling 4 quarters of earnings:

price earnings ratio rolling annual chart

Why Use the Price Dividend Ratio?
I’m not sure where I first learned about this ratio. But Stan Weinstein really made it stand out for me as a very important measure of market valuation in his book: “Secrets For Profiting in Bull and Bear Markets” The power of this ratio comes from the fact that unlike earnings, dividends can not be “massaged” by creative accounting. There are no “EBIT” dividends. They are completely immune from accounting shenanigans. They are either declared and paid in cash or they aren’t.

Also dividends are free from the year to year shocks such as “write-offs” which can affect earnings. Most companies treat their dividends with what you might say approaches reverence because dividends send such a clear and strong signal about their financial strength.

I’m loathe to dip into the fundamental analysis toolbox but from time to time, when the situation warrants, I do. But for the reasons above, I prefer to use the price dividend ratio instead of the much more popular price earnings ratio.

Basically, the ratio tells you how much you have to pay for $1 of dividends. So in a way it can be equated to the “yield” coupon of the stock market. Or the inverse dividend yield of the stock market. And because of that, it has some correlation to the interest rate. So when interest rates are high, usually the dividend yield is also high.

Here is a very long term chart of the S&P 500 Index. I’ve added two data points, one for where we were this time last year and one for now:

sp500 price dividend ratio long term chart
Source: Federal Reserve Bank of San Francisco

Dow Jones Price Dividend Ratio
A year ago, when the Dow was at ~14200, the price dividend ratio was 49. Meaning you would have had to pay almost $50 to get $1 of dividends a year. It also corresponds very closely to the S&P 500’s price dividend ratio (above).

As of now, however, the Dow’s price dividend is a more reasonable 26. This is because of two things. First, and most obviously, the Dow has come down a lot, but also importantly, dividends have increased a healthy 11.7% from a year ago.

As you can see from this long term chart of the Dow’s price dividend ratio, we are right around the long term average for this ratio:

price dividend ratio chart john bogle on mutual funds
Source: John Bogle on Mutual Funds

As we’ve all noticed in the past few days, the market has the ability to reach maximum levels and then to keep pushing into new territory (I’m looking at you VIX). So just because we are now at a much more “normal” price dividend level doesn’t mean that it can’t go lower. For example, here’s a really scary picture of what might/could happen.

Having said that, I’m glad to see this fundamental ratio not clash with other technical indicators which are pointing to a potential market bottom.

The charts above are long term but do not show the most recent years, so if you know of a more up to date price dividend ratio, I’d love to see it. Or if you have access to a platform like Bloomberg, where you can look it up, send me a screengrab. I’m sure the most recent data holds some insight.

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This article has 4 comments:

  •  
    Oct 13 10:01 AM
    I would point interested readers to Stephen Wilcox's "The Adjusted Earnings Yield" in the Financial Analysts Journal No.5 2007.
    Reply
  •  
    Oct 13 10:33 AM
    One thing to take into consideration are the taxes associated with the dividends. Investors take this into consideration when buying a security because this takes away from their real gains. During the 1970's the tax rate on the wealthiest Americans was around 70%. Therefore, investors would have favored capital gains over dividend payments. This would drive the price significantly down on stocks associated with dividends. Conversely, a wave of tax cuts starting in 1982 would have drove prices of stocks higher that were associated with dividends.

    Investors during the 1970's would have been looking for growth companies with capital appreciation and as the tax cuts came in the 1980's, they would be increasingly more attracted to the large dividends in the market. Higher tax rates do depress dividend payments.

    B. Douglas Bernheim did a study called "Tax Policy and the Dividend Puzzle" where he looks at the dividend puzzle with regard to tax policy. He finds some interesting results.
    Reply
  •  
    Oct 13 02:19 PM
    Over the last 12 months, the Diamonds ETF (DIA) has paid dividends of $3.021. Today DIA is roughly $90 so that would make the ratio 29.8.

    Reply
  •  
    Oct 14 11:10 AM
    An interesting article. Actually most investors have been using a different kind of Price/Dividend Ratio called "dividend yield".

    Any look at historical dividend yields however should also be looked from the perspective of interest rates as well.

    Reply
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