Abstract
Decomposing stock returns into news about cash flows (CFs) and discount rates (DRs) is a central issue in asset pricing. Yet there is little consensus on how such a decomposition should be conducted. I develop a decomposition relation showing (i) that dividend yield shocks capture all news about future CFs and DRs that can affect unexpected return, and (ii) shocks to other state variables cause news that, though with no impact on unexpected return, always shift the relative importance of CFs and DRs in driving the time series and cross-sectional variation of stock returns. This decomposition relation explains why (i) dividend yield is a necessary state variable and (ii) return decomposition is sensitive to the choice of state variables. Based on the relation I propose the principles to decompose returns, which I use to revisit some main evidence regarding return and beta decompositions, and to tackle the aggregate earnings puzzle.
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