Some further theoretical and empirical implications regarding the relationship between earnings, dividends and stock prices
In this paper earnings, dividends and stock prices are modelled within a plausible economic framework. The first stage in the analysis involves characterisation of the dynamic behaviour of earnings, for which evidence was found for mean reverting behaviour in the long term, and weaker evidence for mean reversion in the short term. The relationship between dividends and earnings is then examined using a modified form of the Lintner model, the empirical results suggesting that the modified formulation performs as effectively as the original Lintner approach. Based upon the assumption that the share price represents the discounted value of future expected dividends, and that dividends are generated by the modified Lintner model, we then go on to develop the functional form of the corresponding share price relationship. As a consequence of using a generalised model for earnings we are able to examine theoretically, through suitable choice of parameter values, the effect of different earnings processes on share price behaviour. The empirical results imply that changes in earnings per share are important in explaining returns.
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