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

65 Pages Posted: 21 Sep 2022 Last revised: 7 Dec 2023

See all articles by Ricardo De la O

Ricardo De la O

University of Southern California - Marshall School of Business

Xiao Han

City University London - Bayes Business School

Sean Myers

The Wharton School, University of Pennsylvania

Date Written: December 2023

Abstract

What explains cross-sectional dispersion in stock valuation ratios? We find that 75% of dispersion in price-earnings ratios is reflected in differences in future returns, while only 25% is reflected in differences in future earnings growth. This holds at both the portfolio-level and the firm-level. We reconcile these conclusions with previous literature which has found a strong relation between prices and future profitability. Our results support models in which the cross-section of price-earnings ratios is driven mainly by discount rates or mispricing rather than future earnings growth. Evaluating six models of the value premium, we find that most models struggle to match our results, however, models with long-lived differences in risk exposure or gradual learning about parameters perform the best. The lack of earnings growth differences at long horizons provides new evidence in favor of long-run return predictability. We also show a similar dominance of predicted returns for explaining the dispersion in return surprises.

Keywords: price dispersion, return predictability, earnings growth, value premium, cross-sectional models

JEL Classification: E44, G12

Suggested Citation

De la O, Ricardo and Han, Xiao and Myers, Sean, The Return of Return Dominance: Decomposing the Cross-section of Prices (December 2023). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper , USC Marshall School of Business Research Paper Sponsored by iORB, Available at SSRN: https://ssrn.com/abstract=4206091 or http://dx.doi.org/10.2139/ssrn.4206091

Ricardo De la O

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 803
Los Angeles, CA California 90089-1424
United States

Xiao Han (Contact Author)

City University London - Bayes Business School ( email )

United Kingdom

Sean Myers

The Wharton School, University of Pennsylvania ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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