Dynamic Growth Equity Returns

Abstract

Within book/market quintiles, expected return from constant growth equity valuation (static growth expected return, SGER) relates positively with realized returns. However, SGER overstates realized returns for growth stocks and understates realized returns for value stocks. We investigate whether reversion in ROE, which is a SGER input, reconciles these biases. We compare several ROE forecasts using both historical and analysts’ earnings estimates but SGER continues to overstate (understate) returns for growth (value) stocks. On the other hand, the regression of return on ROE for value versus growth stocks is a conditional reduced-form version of a dynamic equity valuation model that recognizes the value-premium. We call return forecasts from these regressions dynamic growth expected returns, DGER, which in large part eliminate the value-versus-growth bias.