We develop an expected return measure from a dynamic equity valuation model as a guide for common equity investment. We show that expected return from Blazenko and Pavlov’s (2009) model of an expanding business where managers have a dynamic option to suspend growth has two terms: one that is easy to calculate with readily available financial market measures and does not require statistical estimation and a component that depends on earnings volatility. We entitle the first portion as static growth expected return (SGER) because it arises not only from the dynamic model, but also from the static constant growth discounted dividend model. SGER is a large portion of expected return from the dynamic model and also changes with corporate profitability in a similar way. Consequently, we investigate SGER on its own as a return measure for common share investing.
Readily available financial measures, like, preferred share dividend yield, or bond yield, give investors in these securities an expected return proxy and a valuable investing guide. Along with a credit assessment, a financial analyst can compare rates across similar securities to make an informed investment decision. On the other hand, for common shares, expected return is more difficult to determine. A complete expected return measure, beyond dividend yield, requires a risk assessment that is more difficult than for preferred shares or bonds because of greater return variability. This variability obscures risk sources and their expected return impact. To structure the study of risk, the finance literature uses asset pricing models like the Capital Asset Pricing Model, the Arbitrage Pricing Theory of Ross (1976), or other factor models that include Fama and French (1992) and Carhart (1997). An analyst can estimate the parameters of these models for expected return guidance.
Rather than estimate parameters of an asset pricing model, there is a literature that either calculates or estimates expected return from share prices and an equity valuation model. The purpose of these implicit expected returns is for the weighted average cost of capital and corporate capital budgeting or for corporate performance evaluation and value based management with financial measures like residual income or EVA?. This objective requires that an expected equity return proxy be unbiased, and therefore, this literature often compares these measures against average realized equity returns. Because this standard is rather demanding, in a study of seven expected return proxies, Easton and Monahan (2005) find that in the entire cross-section of firms, these proxies are unreliable and none has a positive association with realized returns. Easton and Monahan do, however, find better reliability for low long-term consensus growth forecasts and/or high analyst forecast accuracy. Fama and French (2006) forecast returns with corporate profitability, Book/Market, and other corporate financial measures in several regression models. Their forecasts relate positively with realized returns.
The foundation of all asset pricing models is a positive relation between expected return and risk, but Haugen (1995) and Haugen and Barker (1996) report a negative relation. They conclude that either the financial literature misses major risk sources or that investors do not account for risk correctly. Consistent with the first explanation, Connor et. al (2007) argue that there may be many more factors than Fama and French (1992) and Carhart (1997) consider and that each factor may have only a modest return impact. On the other hand, the second explanation contradicts the Efficient Markets Hypothesis. Investors’ risk/return calculus is possibly weak because of the complexity of measuring common share risk and expected return. In particular, there are no easily calculated financial market return measures that guide investors’ risk/return analysis for common equities.
