Price-Earnings Ratios, Dividend Yields and Real Estate Stock Prices

Executive Summary. Both dividend yields and past returns have predictive power for P/E ratios; hence they can be used as tools in forming a market timing and asset allocation strategy in stock markets. This study examines the extent to which changes in real estate returns, reected in changes of property value and dividend yields, can have great effects on P/E ratios. The study is conned to four major real estate stocks in Hong Kong. It shows that a low dividend yield appears to be associated with a relatively high price-to-earning ratio. Variance of dividend yields tends to increase relative to the variance of earnings yield, with a rapid dividend adjustment at higher dividend payout ratios.

by Raymond Y. C. Tse*

Introduction
Compared to the capitalization rate of real estate, little is known about the forecasts of price-toearnings ratios (P/E) of real estate stocks. This is because capitalization rates of real estate are fundamentally different from real estate stocks P/E ratios. Real estate rents are determined in space market whereas earnings reect the performance of a company. There are several reasons why real estate returns have a signicant impact on the performance of property companies. Most developers have signicant amounts of real estate loans; real estate returns should logically have a signicant impact on their protability. A weak real estate market will eventually lead to a reduced cashow for the property company. Tse and Webb (2000) have shown that real estate stocks, with a larger portion of their assets invested in residential property, are most sensitive to changes in residential property prices. While a good prospect of real estate markets justies a higher P/E ratio, concern has arisen that the real estate stock prices may be headed for a downturn because rms share prices have become very high relative to their earnings when the real estate market was booming. Alternatively, it has been argued that high priceearnings ratios have usually been followed by slow growth in stock prices. Campbell and Shiller (1998) found that price-to-earnings ratio was negatively correlated with subsequent stock price growth but uncorrelated with subsequent earnings growth. Furthermore, a high P/E ratio means the earnings yield is low, thus indicating that stocks are expensive relative to alternative investments. Stock market investors are interested in the forecasting power of variables like dividend yields and
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*Hong Kong Institute of Real Estate, Hong Kong and International City University of America, USA or chairman@hkir. com.

Raymond Y. C. Tse

past returns as tools in market timing in highly volatile stock markets. Fama and French (1998) note that the growth style is associated with stocks with relatively high P/E ratios, high protability and consistent growth. However, real estate stocks are differentiated from common stocks with respect to the heterogeneous nature of real estate and inherent volatility of real-estate markets. A major problem in microeconometric analysis of real estate demand involves the capital market constraints that restrict their abilities to borrow against their entire stream of future income. Moreover, the high transaction costs of real estate tend to impede adjustments to changed prices and incomes. In the 1980s, the real estate literature began to pay attention to the choice between real estate and real estate stocks. Unlike the common stocks, various characteristics of the real estate market complicate the transaction process. Among these characteristics are: (1) locational differences of real estate; (2) heterogeneity of real estate; (3) infrequent transactions among sellers and buyers; and (4) complexity arising from the nancial and legal dimensions of the transactions. Unlike the real estate market, stocks trade in continuous auction markets with low transaction costs, large volume, and large pools of informed buyers and sellers. In short run equilibrium, there is some distribution of market prices for identical properties (Quan and Quigley, 1991). In the real estate market, the interaction of agents is more complex than in the stock market (Mantrala and Zabel, 1995). For instance, vacant real estate is more illiquid than occupied real estate (Zuehlke, 1987). Previous research has tended to focus on either how stock returns can be predicted by P/E ratios (Fama and French, 1988b; Fama and French, 1998; Ferson and Harvey, 1997; and Rouwenhorst, 1999) or how stock and real estate markets are related to each other (He, Myer and Webb, 1996; Eichholtz and Hartzell, 1996; Quan and Titman, 1999; and Tse and Webb, 2000). Earlier literature (such as Owen and Grundfest, 1977) shows that there is an analogy between the real estate market and the stock exchange. While important differences exist in these markets, both are subject to similar competitive pressures. In particular, Ross and Zisler (1991) show that real estate returns are roughly comparable to stocks.

This study develops an extension of the dividend adjustment model based on Lintner (1956). The objective is to investigate the ability of dividend yields and past returns to predict future P/E ratios of real estate stocks at the rm level after controlling for error corrections. The results indicate that both dividend yields and past returns have predictive power for P/E ratios; hence they can be used as tools in forming a market timing and asset allocation strategy in stock markets. A particular contribution of this study is that for the rst time it is found that changes in real estate returns, reected in changes of property value and dividend yields, can greatly affect the P/E ratios. The impact of the price growth on the P/E ratios between different real estate stocks is also compared.

Data
This study is conned to four major real estate stocks in Hong Kong, namely Cheung Kong, Sun Hung Kai, Henderson and New World Development. The four major property companies mainly invest in Hong Kong. Thus, these companies are expected to have characteristics similar to that of real estate stocks. However, differences in the market structures between real estate and stocks may affect the behavior of public real estate as a proxy for private real estate. Note that there is a very high concentration of real estate in the stock market in Hong Kong. For instance, the four real estate companies constituted about 13% of the total market capitalization of the blue chips in March 2000. End-of-month average market P/E, stock prices and dividend yields were obtained from the Hong Kong Securities Report between 1991 and 2000. The stock price growth rate represents a onemonth return. The data set spans January 1991 through January 2000. In the data set, no negative P/E ratios are observed. Exhibit 1 presents summary statistics for the P/E ratios, dividend yields and stock price growth rates for the four real estate stocks over the period January 1991 through January 2000. Variation across stocks for all variables is remarkable. For example,

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Exhibit 1
Data Statistics
P/E Panel A: Cheung Kong Mean Median Maximum Minimum Std. Dev. Panel B: Henderson Mean Median Maximum Minimum Std. Dev. Panel C: New World Mean Median Maximum Minimum Std. Dev. Panel D: Sun Hung Kai Mean Median Maximum Minimum Std. Dev. 15.18 15.11 23.29 4.63 4.34 3.69 3.34 9.58 1.55 1.65 7.55 7.19 105.80 40.66 27.37 14.06 12.85 28.23 3.63 5.22 3.96 3.45 11.54 1.71 1.91 4.92 3.28 97.12 45.16 30.65 12.23 12.23 22.70 4.51 3.40 4.97 4.56 12.05 2.18 2.25 7.87 7.34 140.51 45.11 30.63 11.67 9.94 37.12 4.51 6.37 2.62 2.69 4.25 1.18 0.74 8.74 9.15 71.82 41.67 22.14 Yield Price Growth

simple average P/E is 11.67 for Cheung Kong, 12.23 for Henderson, 14.06 for New World and 15.18 for Sun Hung Kai with a standard deviation of 6.37, 3.40, 5.22 and 4.34, respectively. The dividend yield is about 3% to 5%. It is interesting to note that the mean price growth rate is about 5% to 9% with a standard deviation of as high as 30%. For all four stocks, the maximum price decline is about 40%, indicating that they were subject to similar downside risk.

pe(t) pe(t 1) (t),

(1) (2)

(t) (t 1) (t),

Tests for Stationary Component

Early tests of market efciency only examined autocorrelations of stock returns. This study examined the autocorrelations of P/E ratio with a time-varying framework. The P/E ratio pe(t) was modeled as the sum of a random walk, (t), and a rst-order autoregression (AR1) with a slowly decaying parameter, .

where is expected drift and (t) is white noise. The long temporary pe(t) swings assumed in models of an inefcient market imply a slowly decaying . It is hypothesized that P/E ratio would not take long temporary swings away from fundamental values, which is translated into the statistical hypothesis that P/E has slowly decaying stationary components. The tests are based on the proposition that the mean-reverting property of the P/E ratio implies that is less than 1.0. The equation system can be estimated with a time-varying framework. In the results for the sample period (Exhibit 2), 0 1 is consistent with the hypothesis that mean-reverting P/E ratios are important in the variation of P/E ratios. The estimates suggest that predictable variation of the P/E ratio due to mean

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Raymond Y. C. Tse

Exhibit 2
Estimation of Time-Varying Parameter Model
Cheung Kong Henderson 0.972*** (3.013) 0.400*** (2.896) 4.15 0.142 0.278 2.058 New World 1.299*** (5.798) 0.513** (5.231) 14.08 0.242 0.369 1.998 Sun Hung Kai 1.432*** (7.334) 0.542*** (6.144) 6.98 0.276 0.301 1.826

Log Likelihood Adj. R 2 SE DW

1.084*** (2.731) 0.454*** (3.628) 18.55 0.170 0.419 1.520

Notes: t-Statistics appear in parenthesis.

* Signicant at the 0.1 level. ** Signicant at the 0.05 level. *** Signicant at the 0.01 level.

reversion is about 40%55% of its own previous value. Thus, the results add to mounting evidence that P/E ratios are predictable. Furthermore, it is expected that P/E ratio is more predictable than sheer prices because prices cannot take long temporary swings away from their earning power.

distributed-lag function of earnings. For 0 1, the effects of earnings diminish over time. Dividing both sides by P(t) produces: D(t)/ P(t) (1 )D(t 1)/ P(t) kE(t)/ P(t). (7)

The Model
Following Lintner (1956), a rms target dividend D*(t) for year t is assumed to be a constant fraction of earnings E(t), D*(t) kE(t). (3) where: In addition, the change in the actual dividends from t 1 to t is assumed to follow a partial adjustment model: D(t) D(t 1) (D*(t) D(t 1)). Combing Equations (3) and (4) yields: D(t) (1 )D(t 1) kE(t). Equation (5) yields: D(t) k (5) y(t) (1 )y(t 1)/(1 g) k / pe(t). Alternatively,

Thus, y(t) (1 )[D(t 1)/ P(t 1)]/(1 g) k / pe(t), (8)

(4)

y(t) D(t)/ P(t), pe(t) P(t)/ E(t) and g(t) (P(t) P(t 1))/ P(t 1). Thus, (9)

j0

(1 ) jE(t j ) ,

(6)

pe(t) k(1 g)/((1 g)y(t) (1 ) y(t 1)). (10) Hence Equation (10) indicates that P/E ratios are a function of y(t), y(t 1) and g(t), such that:

which implies that dividend at time t is in fact a

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Exhibit 3
Regression Results for Price-to-Earning Ratio
Cheung Kong Constant 2.767*** (0.264) 0.874*** (0.329) 0.513* (0.272) 0.352*** (0.303) 0.277 0.382 1.432 Henderson 3.016*** (0.092) 0.525*** (0.091) 0.368*** (0.058) 0.753*** (0.101) 0.809 0.128 1.847 New World 3.767*** (0.074) 0.175** (0.074) 0.938*** (0.056) 0.632*** (0.124) 0.916 0.121 2.114 Sun Hung Kai 3.675*** (0.043) 0.197*** (0.052) 0.831*** (0.033) 0.858*** (0.100) 0.962 0.068 2.113

g(t)
log(y(t)) Error-correction (t 1) Adj. R 2 SE DW

Notes: t-Statistics appear in parenthesis. The number of observations 37.

* Signicant at the 0.1 level. ** Signicant at the 0.05 level. *** Signicant at the 0.01 level.

pe(t) f ( y(t), y(t 1), g(t)).

(11)

Fama and French (1988a) suggest that dividend yields are highly autocorrelated but slowly meanreverting stationary processes. There is much evidence that variation in the expected stock return generates autocorrelation in the dividend yield. However, if the price growth rate and dividend yield are stationary (mean-reverting), the P/E ratio is also stationary. Thus, it is expected that y(t) and y(t 1) tend to be highly correlated, then the following regression is used: log( pe(t)) 0 1 log( y(t)) 2 g(t) Error-Correctiont1. (12)

assumptions. Equation (13) suggests two possible sources of determinants of P/E ratio: dividend yields and stock price growth rates. An increase in the price-to-earnings ratio could occur in two waysthrough faster growth in stock prices or slower growth in dividend yields. In Equation (13), the current price growth rate g(t) is relevant. This suggests that todays high P/E ratio signals faster growth in stock prices not only in the long term but also in the short term. The implication is that even if investors have a long-term horizon, they still have to make short-term investment decisions. Exhibit 3 presents the results of Equation (13). All the coefcients are signicant, but the regressions are difcult to interpret. The coefcients of the intercept are all positive and relatively stable. The slopes on the two variables have opposite signs, positive in the regression for stock price growth rates and negative for dividend yields. The coefcient on price growth rate g(t) is highest at 0.874 for Cheung Kong, compared to 0.525 for Henderson, 0.175 for New World and 0.197 for Sun Hung Kai. The effect of dividend yields on P/E is strongest in New World and SHK at 0.938 and 0.831, respectively. The negative coefcient on (log) dividend yield suggests some predictability of the P/E
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This requires a two-step estimation procedure: log( pe(t)) 0 1 log( y(t)) 2 g(t) u(t) 0 1 log( y) is regressed yielding: log( pe) 2 g. The following equation is then regressed: log( pe(t)) 0 1 log( y(t)) 2 g(t) 0 3 (log( pet1) 1 log( yt1) 2 gt1). (13)

Equation (13) provides a simple intuition for Equation (11), and produces approximately unbiased estimates of the P/E ratio under more general

Raymond Y. C. Tse

ratio due to the mean reversion of dividend yields. The negative P/E slopes say that P/E ratio is likely to be high when current dividends are low relative to current stock prices. High P/E ratios tend to reduce the earnings yield on stocks relative to returns on other investments. A lower dividend yield may indicate that rms retain cash for internal use rather than for dividend payments. Dividends provide a cheaper source of capital and, if wisely invested, will possibly increase earnings and dividends in the future. Thus, lower dividends are usually paid to avoid higher costs of external nancing (Myers, 1984). All of these changes suggest possibly higher P/E ratios if earnings are expected to grow persistently faster than before. There is no apparent trend in P/E ratios during the period under concern. Based on the historical behavior of stock prices, P/E and dividend yields, there is little evidence that P/E ratio is high when dividend yield is high. However, there is evidence that P/E ratio is high when price growth rate is high. The P/E ratio was high relative to the dividend yield before 1997. The sudden decreases in the difference between the P/E and dividend yield in 1998 was largely due to the Asian Financial Crisis, resulting in a substantial drop in stock prices. Some of the decline in the P/E ratio was probably due to decreases in stock prices and increases in dividend yields, but most of it is unexpected. Note that dividend yield is driven by expected future returns and expectations about future dividends. However, dividend yields are essentially unpredictable (Campbell, 1991; and Cochrane, 1991). There is, however, a problem in using Equation (10) to estimate the P/E ratio, since both and k remains unknown. In general, stock prices, dividends and earnings have different volatilities. Short-term changes in P/E ratios and dividend yields are largely due to changes in stock prices, rather than earnings and dividends respectively. In other words, changes in stock prices lead to simultaneous changes in P/E ratio and dividend yields. How is the volatility of these three variables connected?

Put a bit differently, the variances of price growth rate, P/E ratio and dividend yields are closely connected. Taking the variance of both sides of Equation (10) produces: Var( pe(t)) Var{k /[ y(t) (1 )y(t 1)/(1 g(t))]}. (14) However, Var( y(t)) Var( y(t 1)) Var( y). Thus,
Var( pe) (k)2 /(Var( y) (1 )2 Var( y)/Var( g)),

Var( pe)Var( y) (k)2 /(1 (1 )2 / g2),

(15)

where g2 Var( g). Since 0 k 1 (for , k 1), and (1 )2 / g2 0, it can be determined that: Var( pe)Var( y) 1. Since the reciprocal of the P/E ratio 1/ pe earnings/price, Var(1/ pe) 1/Var(pe) represents the variance of the earnings yield (earning-to-price ratio). However, shareholders prefer a steady stream of dividends. This result is also consistent with Fama and French (1988b) that dividend tends to be more stable than earnings, implying that variance of dividend yield should be smaller than the variance of earning yield. Equation (16) implies variance of dividend yields tends to increase relative to the variance of earning yield, when the dividend adjustment speed () and dividend payout ratio (k) increase.

Conclusion
This article presents a methodology for investigating the behaviors of P/E ratio on real estate stocks. The results have important implications with respect to the predictability of P/E ratios. However, this study focuses on real estate stocks at the rm level. In Hong Kong a good deal of stock market volatility can be attributed to the real estate market (Tse, 2001). For example, due to the nancial turmoil in October 1997, the Properties Stock Index performed poorly during this period. The property stock P/E ratio decreased from 15.7 in July 1997 to less than 5.0 in July 1998, down by nearly 70%, which is the lowest among all the Hong Kong

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stock sub-indices. Real estate stocks are, however, differentiated from common stocks with respect to the heterogeneous nature of real estate and the inherent volatility of real-estate markets. This study shows that an increase in a P/E ratio could occur in two waysthrough faster growth in stock prices or slower growth in dividend yields. The implication is that there is some predictability of the P/E ratio due to the mean reversion of dividend yields. A low dividend yield appears to be associated with a relatively high P/E, since a lower dividend yield may indicate that dividends are retained for internal use. Thus, lower dividends are paid to avoid higher nancing costs and increase future prots. Consequently, a higher prot will lead to higher stock prices and P/E ratio. These ndings are consistent with Myerss (1984) pecking order and stakeholder hypotheses of dividend behavior. There is also evidence that P/E ratio is high when price growth rate is high. This study indicates that a high P/E ratio signals faster growth in short-term stock prices. The results also indicate that variance of dividend yields tends to increase relative to the variance of earning yield, with a rapid dividend adjustment and higher dividend payout ratio. The extent to which this model can be applied to different types of stocks must nevertheless await further research. Additional research in this area could extend the results to measure the impact of the differences on pricing or trading customs.

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