Why stock valuation hinges more on returns than future earnings
Growth stocks don’t generate the long-term returns that would justify their high multiples, according to the 2023 Jacobs Levy Center’s ‘Best Paper’ co-authored by the Wharton School’s Sean Myers.
“Stocks that look expensive, or those with high price-to-earnings ratios, or multiples, seem to deliver much lower returns than previously thought,” says Wharton finance professor Sean Myers, who co-authored the paper.
“This is particularly concentrated at very long horizons,” Myers continues. “It’s not the case that [stocks with high multiples] immediately give you very bad returns. But if you track these companies over a long horizon, you find that their returns are a lot lower than we thought.” The paper analyzes the valuations of all listed U.S. stocks from 1963 to 2020 over 10-year rolling periods.
The paper condensed its key findings to state that 75% of the “cross-sectional dispersion” in valuation ratios shows up in the differences in future returns, while the remaining 25% is reflected in future earnings growth. Put another way, the returns on investment were three times as big as earnings growth in driving the stock valuations of firms. “The differences in [price-earnings] multiples between firms seem to mostly predict lower future returns for the high-multiple firms,” Myers says. “It doesn’t indicate that the high-multiple firms will actually have better earnings growth than their peers.”
Myers says it is hard to explain why the valuation of stocks with high multiples was high initially. “These stocks that have very high multiples don’t go on to have extraordinary earnings growth. Instead, what we see is that their prices just gradually come down over time, which seems to indicate that either their price was too high to begin with, or there’s some very large risk premium out there that has not been identified beforehand.”
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