Growth Expectations, Dividend Yields, and Future Stock Returns

58 Pages Posted: 30 Oct 2014 Last revised: 20 Nov 2014

See all articles by Zhi Da

Zhi Da

University of Notre Dame - Mendoza College of Business

Ravi Jagannathan

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

Jianfeng Shen

UNSW Australia Business School, School of Banking and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: November 2014

Abstract

According to the dynamic version of the Gordon growth model, the long-run expected return on stocks, stock yield, is the sum of the dividend yield on stocks plus some weighted average of expected future growth rates in dividends. We construct a measure of stock yield as a model-imposed affine combination of dividend yield and an expected dividend growth proxy measured from sell-side analysts' near-term earnings forecasts. Stock yield predicts US stock index returns well, with an out-of-sample R-squared that is consistently above 2% at monthly frequency over our sample period. When both dividend yield and expected dividend growth are used as explanatory variables in a multivariate regression without any coefficient restriction to predict future stock returns, the in-sample R-squared is almost the same as that for stock yield, but the out-of-sample R-squared is only about half of that for stock yield, which suggests that dividend yield, expected dividend growth and expected future returns are tied together through the present-value relation. Stock yield also predicts future stock index returns in other G7 countries and returns of US stock portfolios formed by sorting stocks based on firm characteristics, at various horizons. The findings are consistent with a single dominant factor driving expected returns on stocks over different holding periods. That single factor extracted from the cross section of stock yields using the Kelly and Pruitt (2013) partial regressions method predicts stock index returns better. The performance of the Binsbergen and Koijen (2010) latent factor model for forecasting stock returns improves significantly when stock yield is included as an imperfect observation of expected return on stocks. Consistent with folk wisdom, stock returns are more predictable coming out of a recession. Our measure performs as well in predicting stock returns as the implied cost of capital, another common stock yield measure that uses additional information.

JEL Classification: G12; G14

Suggested Citation

Da, Zhi and Jagannathan, Ravi and Shen, Jianfeng, Growth Expectations, Dividend Yields, and Future Stock Returns (November 2014). Finance Down Under 2015 Building on the Best from the Cellars of Finance Paper. Available at SSRN: https://ssrn.com/abstract=2516040 or http://dx.doi.org/10.2139/ssrn.2516040

Zhi Da (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

Ravi Jagannathan

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

Jianfeng Shen

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia

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