The Cross Section of Long-Term Expected Returns

Abstract

Effective capital budgeting decisions require reliable estimates of long-term expected returns. I extract a predictor for long-term returns from the book-to-market ratio by controlling for its variation associated with long-term expected profitability. The resulting predictor reliably describes the cross section of returns out-of-sample for at least five years, even when focusing exclusively on large-cap stocks and controlling for expected-return estimates generated by implied cost of capital models, factor models, and characteristic-based models. My results have important implications for improving our cost of equity estimates.