Damodaran uses valuation fundamentals to predict a (negative!) 18% ‘dividend cliff’

The S&P turns out, weirdly, to have been the place to have your money this year--for now.  ”I may be overly pessimistic, but the ‘dividend cliff’ scares me and I am planning for the eventuality that the tax code will change drastically on January 1, 2013,” predicts Professor Aswath Damodaran (NYU Stern School of Business).

“A sharp correction is ahead for stocks collectively and especially so for high dividend paying stocks,” if, on Jan. 1, 2013, certain provisions of the federal tax code are allowed to return to pre-2003 levels—thereby pushing the domestic economy over the so-called “fiscal cliff.” (For more dire predictions generally, see this week’s release from the Tax Policy Center of the Urban Institute/Brookings Institution, “Toppling Off the Fiscal Cliff: Whose Taxes Rise and How Much?”).

In particular, Damodaran takes a look at what would happen should the current 15% tax rate on corporate dividends revert to an ordinary income tax rate. Working with “real numbers”—including expected stock returns and the resulting equity risk premia and risk-free rates—Damodaran ultimately concludes the fiscal cliff will cause stocks with a 4% dividend yield to suffer an 18% price drop. By comparison, stocks with a 0% dividend yield will see prices drop by “only” 7%.

To read his complete analysis, which also notes the “weak links” in his assumptions and invites readers to test their own on the accompanying spreadsheets, visit the professor’s recent blog post at Musings on Markets.