Cash Flow Risk and Discount Rate Risk of Aggregate Stock Returns

Abstract

The fact that aggregate stock returns do not predict future cash flow news, measured in dividend growth, has been a major challenge to financial economists. This paper presents new evidence on the predictability of future cash flow news, and reconciles this with the unpredictability of dividend growth. It argues that dividend growth is not predictable because it is subject to corporate policies - firms have complete discretion on the retention or payout of earnings. This prediction difficulty can be largely alleviated by using the alternative cash flow measure of return on equity - the ratio of retained earnings plus dividend to book equity; in this case the proper predictive variable is the book-to-market ratio. This study shows that both expected returns and cash flows of the market portfolio are predictable using the book-to-market. For the 1930-2004 period the book-to-market explains more of the variation of future cash flows than the variation of future equity returns. The predictable component of future cash flows comes from retained earnings, not dividends, consistent with the notion that dividend is not predictable due to corporate policies.