Stock Prices, Returns and Dividend Yields

The predictive ability of the dividend-price ratio for future stock returns does not necessarily imply that dividend-price ratios predict future stock prices. Stock returns consist of both a capital gain and a dividend yield component, and we show that predictability of stock returns by lagged dividend-price ratios mainly reflects predictability of future dividend yields, which make up a significant component of average returns. We propose a novel loglinear approximation of stock returns into a capital gain and a dividend yield component and derive testable restrictions of nonpredictability of capital gains. Using Monte Carlo simulations, we show that not accounting for the dividend yield component of returns leads to overrejections of unpredictability both in one-period and multi-period tests. Our results have wide-ranging implications for the way we think financial markets work, asset pricing and asset allocation