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The return of return dominance: Decomposing the cross-section of prices

Ricardo Delao,Xiao Han,S. Myers

Published 2025 in Journal of Financial Economics

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 differences in future returns, while less than 30% is reflected in differences in future earnings growth. The lack of predictable earnings growth implies returns are much more predictable than previously estimated. Additionally, changes in predicted returns are more important than changes in predicted 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. Our results support models in which the cross-section of stock valuation ratios is driven mainly by discount rates or mispricing rather than future earnings growth.

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