Understanding Stock Price Volatility: The Role of Earnings
Posted: 7 Feb 2007
In an efficient capital market, asset prices vary when investors change their expectations about cash flows, discount rates, or both. Using dividends to measure cash flows, previous research shows that the aggregate dividend-price ratio varies due to changes in expected discount rates (returns) rather than expected cash flows. In contrast, using accounting earnings instead of dividends as a measure of cash flows, this paper shows that as much as 70% of the variation in the dividend-price ratio can be explained by changes in expected earnings. Moreover, the paper documents a significant negative correlation between expected returns and expected earnings, suggesting that variations in a common factor to both may generate significant price volatility. The results are consistent with the dividend-policy irrelevance hypothesis.
Keywords: Accounting valuation, expected-return variation, profitability, equity premium, variance
JEL Classification: E32, G12, G14, G35, M41
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