Back-Tests of the Dividend Discount Model Using Time-Varying Cost of Equity
20 Pages Posted: 16 Sep 2016
Date Written: September 14, 2016
Abstract
This paper examines prediction errors in the general dividend discount model using a back-test method. The prediction errors are based on realized dividends, terminal stock prices, and estimates of time-varying discount rates. Models of varying lengths are examined in our tests. We include firms with a continuous record of dividend payments over the 20 years in our sample. We find that prediction errors vary from a high of approximately 55% to a low of 2% depending on the length of period used to calculate the estimated model. Reducing the number of dividends and the horizon date in the model reduces prediction error. Prediction error is also reduced by using time-varying equity discount rates when market volatility increases.
Suggested Citation: Suggested Citation