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RFS Advance Access originally published online on October 28, 2005
Review of Financial Studies 2006 19(1):159-194; doi:10.1093/rfs/hhj001
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© The Author 2005. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Explaining Returns with Cash-Flow Proxies

Peter Hecht
Harvard Business School

Tuomo Vuolteenaho
Arrowstreet Capital, L.P.

Address correspondence to Tuomo Vuolteenaho, Arrowstreet Capital, L.P., 44 Brattle Street 5th Floor, Cambridge, MA 02138, or e-mail: tvuolteenaho{at}arrowstreetcapital.com.

Stock returns are correlated with contemporaneous earnings growth, dividend growth, future real activity, and other cash-flow proxies. The correlation between cash-flow proxies and stock returns may arise from association of cash-flow proxies with one-period expected returns, cash-flow news, and/or expected-return news. We use Campbell’s (1991) return decomposition to measure the relative importance of these three effects in regressions of returns on cash-flow proxies. In some of the popular specifications, variables that are motivated as proxies for cash-flow news also track a nontrivial proportion of one-period expected returns and expected-return news. As a result, the R2 from a regression of returns on cash-flow proxies may overstate or understate the importance of cash-flow news as a source of return variance.


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