Predictability and the Earnings-Returns Relation
Posted: 26 Nov 2008
Date Written: November, 25 2008
This paper studies the effects of predictability on the earnings-returns relation for individual firms and for the aggregate. We demonstrate that prices better anticipate earnings growth at the aggregate level than at the firm level, which implies that random-walk models are inappropriate for gauging aggregate earnings expectations. Moreover, we show that the contemporaneous correlation of earnings growth and stock returns decreases with the ability to predict future earnings. Our results may therefore help explain the apparently conflicting recent evidence that the earnings-returns relation is negative at the aggregate level but positive at the firm level.
Keywords: Valuation, profitability, predictability, asset pricing
JEL Classification: E32, G12, G14, M41
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