{"id":226314,"date":"2025-06-26T10:36:30","date_gmt":"2025-06-26T14:36:30","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=226314"},"modified":"2025-06-27T09:26:20","modified_gmt":"2025-06-27T13:26:20","slug":"are-discount-rates-more-important-than-future-earnings-for-stock-valuation","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/are-discount-rates-more-important-than-future-earnings-for-stock-valuation\/","title":{"rendered":"Are Discount Rates More Important than Future Earnings for Stock Valuation?"},"content":{"rendered":"\n<p><em>The article &#8220;Are Discount Rates More Important than Future Earnings for Stock Valuation?&#8221; was originally posted on <a href=\"https:\/\/alphaarchitect.com\/stock-valuations\/\">Alpha Architect<\/a> blog.<\/em><\/p>\n\n\n\n<p>A longstanding belief in investing is that price ratios like P\/E and P\/B reflect expectations for future growth. But this new research turns that idea on its head. This analysis finds that most of the variation in price ratios across stocks is not about future earnings\u2014it\u2019s about differences in expected returns. In fact, over 75% of the cross-sectional variation in P\/E ratios is driven by future return differences, not growth expectations. This challenges many common asset pricing models and changes how investors should think about value, growth, and long-term return forecasting.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-the-return-of-return-dominance-rethinking-stock-valuation-drivers\">The Return of Return Dominance: Rethinking Stock Valuation Drivers<\/h2>\n\n\n\n<ul class=\"wp-block-list\">\n<li>Ricardo&nbsp;Delao,&nbsp;Xiao&nbsp;Han,&nbsp;Sean&nbsp;Myers&nbsp;<\/li>\n\n\n\n<li>The Journal of Financial Economics, July 2025<\/li>\n\n\n\n<li>A version of this paper can be found&nbsp;<a href=\"https:\/\/papers.ssrn.com\/sol3\/papers.cfm?abstract_id=4206091\" target=\"_blank\" rel=\"noreferrer noopener\">here<\/a><\/li>\n\n\n\n<li>Want to read our summaries of academic finance papers? Check out our&nbsp;<a href=\"https:\/\/alphaarchitect.com\/category\/architect-academic-insights\/academic-research-insight\/\" target=\"_blank\" rel=\"noreferrer noopener\">Academic Research Insight<\/a>&nbsp;category<\/li>\n<\/ul>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-key-academic-insights\">Key Academic Insights<\/h2>\n\n\n\n<p>E<strong>xpected Returns, Not Growth, Drive Valuation Differences<\/strong><br>Contrary to the belief that high valuations signal high growth, the paper shows that P\/E ratios mostly reflect lower expected returns, not higher future earnings growth. This applies to both individual stocks and growth\/value portfolios.<\/p>\n\n\n\n<p><strong>Price Ratios Misinterpreted in Models<\/strong><br>Classic asset pricing models often attribute valuation differences to growth expectations. However, most of these models can\u2019t explain the magnitude of return dominance found in the data. Models assuming persistent risk exposure or slow-learning mispricing better fit the evidence. This reinforces what Alpha Architect describes about the importance of understanding valuation signals in terms of&nbsp;<a href=\"https:\/\/alphaarchitect.com\/value-and-quality-stocks\/\" target=\"_blank\" rel=\"noreferrer noopener\">profitability and quality<\/a>\u2014not just presumed growth.<\/p>\n\n\n\n<p><strong>Price-to-Book\u2019s Predictive Power Comes from Today\u2019s Profitability<\/strong><br>The study reconciles earlier research suggesting P\/B ratios predict profitability by showing that P\/B is strongly related to&nbsp;<em>current<\/em>&nbsp;earnings-book ratios\u2014not future earnings growth.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-practical-applications-for-investment-advisors\">Practical Applications for Investment Advisors<\/h2>\n\n\n\n<p><strong>Look Deeper Than Price Ratios<\/strong><br>High P\/E or P\/B ratios don\u2019t necessarily signal high-growth companies. Instead, they often mean the market is demanding lower returns. Advisors should help clients understand that what looks like \u201cquality growth\u201d may just be expensive and low-return.<\/p>\n\n\n\n<p><strong>Rethink Growth Stock Exposure in Long-Term Portfolios<\/strong><br>Since growth stocks with high price ratios tend to deliver lower long-term returns, portfolios tilted too heavily toward these may underperform over time\u2014especially in environments where valuation compression matters.<\/p>\n\n\n\n<p><strong>Build Models that Align with Real Return Drivers<\/strong><br>Investment strategies and screens should shift toward identifying persistent return-related features (like earnings yield, profitability, or mispricing signals), rather than just using price multiples as crude growth proxies. It echoes this article about the&nbsp;<a href=\"https:\/\/alphaarchitect.com\/the-quality-factor-what-exactly-is-it\/\" target=\"_blank\" rel=\"noreferrer noopener\">quality factor<\/a>, which explains how factors like quality and profitability provide more reliable information than price ratios alone.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-how-to-explain-this-to-clients\">How to Explain This to Clients<\/h2>\n\n\n\n<p>\u201cYou may have heard that when a stock has a high P\/E ratio, it means the company is expected to grow fast. But new research shows that\u2019s not the full picture. In fact, these high prices often mean the stock is expected to deliver lower returns going forward\u2014not necessarily that it will grow faster. That\u2019s why we take valuation signals carefully and combine them with other indicators to guide your long-term strategy.\u201d<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-the-most-important-chart-from-the-paper\">The Most Important Chart from the Paper<\/h2>\n\n\n\n<p>The table below shows the results for the price\u2013earnings ratio and the price\u2013book ratio. Panel A shows separate univariate regressions of future returns on the price\u2013earnings ratio and the price\u2013book ratio. At every horizon, we see find that the price\u2013earnings ratio predicts future returns with a larger magnitude coefficient and a higher&nbsp;R2&nbsp;than the price\u2013book ratio. As shown in the final column of Panel A, nearly half (47.6%) of all variation in ten-year returns is explained by the price\u2013earnings ratio.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"800\" height=\"532\" data-src=\"https:\/\/www.interactivebrokers.com\/campus\/wp-content\/uploads\/sites\/2\/2025\/06\/The-return-of-return-dominance_-Decomposing-the-cross-section-of-prices-alpha-architect.jpg\" alt=\"price\u2013earnings ratio and the price\u2013book ratio\" class=\"wp-image-226319 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2025\/06\/The-return-of-return-dominance_-Decomposing-the-cross-section-of-prices-alpha-architect.jpg 800w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2025\/06\/The-return-of-return-dominance_-Decomposing-the-cross-section-of-prices-alpha-architect-700x466.jpg 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2025\/06\/The-return-of-return-dominance_-Decomposing-the-cross-section-of-prices-alpha-architect-300x200.jpg 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2025\/06\/The-return-of-return-dominance_-Decomposing-the-cross-section-of-prices-alpha-architect-768x511.jpg 768w\" data-sizes=\"(max-width: 800px) 100vw, 800px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 800px; aspect-ratio: 800\/532;\" \/><\/figure>\n\n\n\n<p><em>The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.&nbsp;Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index<\/em>.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-abstract\">Abstract<\/h2>\n\n\n\n<p>What explains cross-sectional dispersion in stock valuation ratios? We find that 75% of dispersion in price-earnings ratios is reflected in differences in future returns, while only 25% is reflected in differences in future earnings growth. This holds at both the portfolio-level and the firm-level. We reconcile these conclusions with previous literature which has found a strong relation between prices and future profitability. Our results support models in which the cross-section of price-earnings ratios is driven mainly by discount rates or mispricing rather than future earnings growth. Evaluating six models of the value premium, we find that most models struggle to match our results, however, models with long-lived differences in risk exposure or gradual learning about parameters perform the best. The lack of earnings growth differences at long horizons provides new evidence in favor of long-run return predictability. We also show a similar dominance of predicted returns for explaining the dispersion in return surprises.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>This analysis finds that most of the variation in price ratios across stocks is not about future earnings\u2014it\u2019s about differences in expected returns.<\/p>\n","protected":false},"author":152,"featured_media":206647,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[339,338,341],"tags":[],"contributors-categories":[13651],"class_list":{"0":"post-226314","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-data-science","8":"category-ibkr-quant-news","9":"category-quant-development","10":"contributors-categories-alpha-architect"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- This site 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