Price Primarily Predicts Future Returns, Not Future Earnings Growth

A central question in equity valuation is, why do stock valuation ratios (like price/earnings) differ so widely across companies?

Ricardo Delao, Xiao Han, and Sean Myers, authors of "The Return of Return Dominance: Decomposing the Cross-Section of Prices," which was published in the July 2025 Journal of Financial Economics, set out to find the answer.

Their research rigorously tested whether these differences are primarily driven by expectations of future returns or by expectations of future earnings growth. Their analysis covered all US common stocks listed on the New York Stock Exchange, American Stock Exchange, and Nasdaq over the period 1963-2020. They conducted their analysis at both the portfolio and individual firm level and also evaluated how well six leading models of the value premium (the tendency of value stocks to outperform growth stocks) explained their findings.

Key Findings

• Return Dominance: Contrary to common belief, differences in expected earnings growth play a much smaller role in explaining why some stocks trade at higher or lower valuation multiples as about 75% of the variation in price/earnings ratios across stocks was explained by differences in future returns, while only 25% was due to differences in future earnings growth. They say: “A higher price/earnings ratio predicted both higher future earnings growth and lower future returns, and these estimates were highly significant at nearly every horizon. However, lower returns tended to play a larger role in explaining the cross-sectional dispersion in price/earnings ratios. In other words, high price/earnings ratios primarily predict lower future returns.”
• Consistency Across Levels: The dominance of return predictability held true at both the portfolio and firm level.
• Implications for Value Premium Models: Most value premium models fail to match these findings. However, models that assume either long-lived differences in risk exposure or gradual learning about economic parameters perform better.

• Discount Rates and Mispricing Matter: Their findings support models where discount rates (required returns) or mispricing—not just growth prospects—drive valuation differences. Most traditional value premium models fail to explain this dominance of return predictability, except those that incorporate persistent risk differences or gradual learning about economic fundamentals.
• Long-Run Predictability: The lack of significant differences in long-term earnings growth across stocks provides evidence that long-run return predictability is a key factor in valuation spreads. The dominance of return predictability also extends to explaining unexpected return surprises.
• Profitability and Valuation Ratios: The relationship between price/book ratios and future profitability is driven almost entirely by current profitability, not by information about future earnings growth. Most of the variation in cash flow news comes from unexpected current earnings growth, not from forecasts about future growth.

Their findings led the authors to conclude: “Future profitability is approximately equal to the sum of future earnings growth and the current earnings/book ratio.”

They explain: “We then demonstrate that the documented relationship between the price/book ratio and future profitability is driven almost entirely by the correlation between the current price/book ratio and the current earnings/book ratio. In other words, the price/book ratio is related to future profitability not because it is informative about the future earnings growth of a stock, but instead because it is related to current level of profitability.”

They add: “Almost all the variation in their measure of cash flow news comes from unexpected current earnings growth, rather than information about future earnings growth.”

Summarizing, they say: “These results indicate that risk premia and/or mispricing explain most cross-sectional differences in price/earnings ratios, which has important implications for cross-sectional asset pricing models.”

In a subsequent paper, "The Cross-Section of Subjective Expectations: Understanding Prices and Anomalies," Delao, Han, and Myers used professional analyst forecasts to decompose cross-sectional differences in P/E ratios. They specifically analyzed how high P/E ratios are accounted for by both low expected returns and overly high expected earnings growth, as forecasted by analysts. The paper investigated the dynamics between prices, earnings growth, and returns. The authors found that the low subsequent returns of high P/E stocks are one third explained by risk premiums and two-thirds explained by the expected earnings growth, due to analysts’ overoptimism. They found that changes in prices, earnings growth, and returns tend to move together over time in a way that suggests investors update their beliefs gradually. Rather than reacting strongly to new information, expectations adjust slowly, indicating a learning process rather than an immediate overreaction to recent news.

Key Takeaways for Investors

Focus on Expected Returns, Not Just Growth

When evaluating stocks, differences in expected returns—driven by discount rates or potential mispricing—are far more important than differences in expected earnings growth. This challenges the conventional wisdom that high-valuation stocks simply reflect superior growth prospects.

Role of Risk and Sentiment

High dispersion in valuation ratios signals differences in expected returns, which are shaped by risk, discount rates, and market sentiment—not just by growth expectations.

Empirical research confirms that investor sentiment significantly affects P/E ratios, even after accounting for fundamentals. High optimism leads to higher prices and valuation ratios for favored stocks, while pessimism depresses prices for out-of-favor stocks. Ignoring sentiment can lead to poor investment decisions, especially in euphoric or fearful markets.

When investor sentiment is high (optimism dominates), investors tend to overestimate future performance and underestimate risk. This leads to higher stock prices and elevated valuation ratios for favored stocks, as optimistic investors are more willing to pay a premium. In markets with short-sale constraints, optimistic investors set the price, further amplifying the effect.

Conversely, when sentiment is low (pessimism dominates), investors underestimate future performance and overestimate risk, resulting in lower prices and depressed valuation ratios for out-of-favor stocks.

Look Beyond Growth Forecasts

Delao, Han, and Myers provided robust evidence that differences in stock valuations are primarily about expected returns, not future earnings growth. This finding challenges the traditional focus on growth as the main driver of valuation spreads and underscores the importance of understanding discount rates, risk perceptions, and market sentiment in investment decisions.

For investors, the key takeaways are to look beyond growth forecasts, focus on the long-term return predictability that valuation ratios signal, and have an understanding of valuation signals in terms of not just presumed growth but also profitability and quality.

Myers discusses the paper in this video.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.