In the long run, returns on investment drive the price-earnings ratios that determine the stock valuations of firms far more than profitability does, according to a new research paper by experts at the Wharton School and elsewhere, titled “The Return of Return Dominance: Decomposing the Cross-section of Prices.” That finding has added a new dimension to the popular belief that price-earnings ratios are more strongly related to future profitability than they are to future returns. The paper won the 2023 Best Paper prize from Wharton’s Jacobs Levy Equity Management Center for Quantitative Financial Research, and will be recognized at the Frontiers in Quantitative Finance Conference in September.
“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.”
Read more at Knowledge at Wharton.