The Return of Return Dominance: Decomposing the Cross-section of Prices

Abstract

Are stock valuation ratios mainly informative about future earnings growth or future returns? Using a variance decomposition, we find that over 70% of cross-sectional variation in price-earnings ratios is reflected in cross-sectional differences in future returns, while less than 30% is reflected in cross-sectional differences in future earnings growth. The lack of predictable earnings growth implies returns are much more predictable than previously estimated. Additionally, changes in predicted future returns are more important than changes in predicted future earnings growth for explaining innovations in price-earnings ratios and current realized returns. We reconcile these results with previous literature which has found a strong relation between prices and future profitability. These results are consistent with models in which the cross-section of stock valuation ratios is driven mainly by discount rates or mispricing rather than differences in future earnings growth.

Keywords: Price Variation, Cash Flow, Discount Rate, Return Predictability

JEL Classification: E44, G12