In the long run, returns on investment drive the price-earnings ratios that determine the stock valuations of firms far more than profitability does, according to a new research paper by experts at Wharton and elsewhere, titled “The Return of Return Dominance: Decomposing the Cross-section of Prices.” That finding has added a new dimension to the popular belief that price-earnings ratios are more strongly related to future profitability than they are to future returns. The paper won the 2023 Best Paper from Wharton’s Jacobs Levy Equity Management Center for Quantitative Financial Research and the Rodney L. White Center’s 2022 Marshall Blume First Prize in financial research. It will also be recognized at the Frontiers in Quantitative Finance Conference in September.

“Stocks that look expensive, or those with high price-to-earnings ratios, or multiples, seem to deliver much lower returns than previously thought,” said Wharton finance professor Sean Myers, who co-authored the paper with Ricardo De la O, professor of finance and business economics at the University of Southern California’s Marshall School of Business, and Xiao Han, lecturer in finance at the Bayes Business School in the City, University of London.

“This is particularly concentrated at very long horizons,” Myers continued. “It’s not the case that [stocks with high multiples] immediately give you very bad returns. But if you track these companies over a long horizon, you find that their returns are a lot lower than we thought.” The paper analyzed the valuations of all listed U.S. stocks from 1963 to 2020 over 10-year rolling periods. The model in the paper used industry benchmarks and the average P/E multiples of all firms to determine what represents a high multiple.

The paper condensed its key findings to state that 75% of the “cross-sectional dispersion” in valuation ratios shows up in the differences in future returns, while the remaining 25% is reflected in future earnings growth. Put another way, the returns on investment were three times as big as earnings growth in driving the stock valuations of firms. “The differences in [price-earnings] multiples between firms seem to mostly predict lower future returns for the high-multiple firms,” Myers said. “It doesn’t indicate that the high-multiple firms will actually have better earnings growth than their peers.”

Myers said it is hard to explain why the valuation of stocks with high multiples was high initially. “These stocks that have very high multiples don’t go on to have extraordinary earnings growth. Instead, what we see is that their prices just gradually come down over time, which seems to indicate that either their price was too high to begin with, or there’s some very large risk premium out there that has not been identified beforehand.”

“Stocks that look expensive, or those with high price-to-earnings ratios, or multiples, seem to deliver much lower returns than previously thought.”— Sean Myers

According to the paper, the bigger driver of stock valuation ratios than future earnings growth is either risk premia (people paying more for certain stocks because they hedge specific risks) or mispricing. The study generally found insufficient support for risk premia in driving high multiples. “Models based on risk premia struggle to match our results, whereas models based on mispricing perform better,” the paper stated.

‘Growth Firms’ Is a Misnomer

Firms whose stocks enjoy high multiples are called “growth firms,” where the stock price is high relative to their current earnings. If these earnings grow quickly, then they generate returns that would justify their high price, Myers said. “But if those firms do not grow faster than their peers, calling them growth firms is a misnomer. And because they don’t actually grow substantially faster [than their industry peers], they end up having worse returns.”

Stocks with high multiples don’t always let down investors. Investors would certainly get a high return if they had bought a high-multiple stock on its upswing — and therefore at a relatively lower price before it reaches its peak, Myers said. But the trajectory of those gains doesn’t survive in the long run. “If you wait long enough, the multiples of most firms tend to balance out over time,” he added. “If there’s a temporary upswing for the first few years, you might make strong returns. But eventually, as you get to year 6 or 7, what we see is that on average, most firms’ multiples converge over time, say a 5-to-10-year period.”

Stock Valuation: Riding Boom and Bust Cycles

The study found evidence of the leveling of valuations in recent expansions and contractions of the stock market, in 10-year cycles. “If you were to buy stocks of all of the high-multiple firms in the early 1990s and hold them for 10 years, you do fairly well because that’s essentially leading into the dotcom bubble,” Myers said. “However, in the subsequent 10 years [or the dotcom bust], if you were to buy the stocks of all the high-multiple firms in 2000 and hold them for 10 years, you do much worse than buying the low-multiple stocks.” The subsequent decade again saw a resurgence of high-multiple firms, or technology companies such as Apple and Amazon that are called growth stocks. That was followed by price corrections in this decade as tech stocks lost their earlier allure.

If growth stocks deliver lower returns than their high multiples suggest, the dice turns in favor of the so-called value stocks at the other end of the spectrum that have relatively lower multiples. Value stocks are typically those of firms such as retailers like Walmart, utilities, or banks that have stable revenue streams but with less attractive profit margins than those of growth stocks.

“On average, there’s a much higher return on value stocks compared to growth stocks, particularly over long horizons,” Myers said. “High-multiple stocks just don’t have enough fundamental growth to justify their initial price, and so you consistently see lower returns.”

Myers and his co-authors stumbled onto their findings by accident. While working on a different project, they decided to check the conventional wisdom that a firm’s multiple was an indicator of its future growth. “What we had learned in school was that differences in firms’ multiples are largely explained by differences in future fundamental growth,” he said. “But we couldn’t get that result. We thought we had made a mistake, and so we started digging into this. After a lot of effort, we realized that growth stocks weren’t growing faster than their peers. It didn’t look like the stock market was particularly efficient in assigning different multiples to firms.”

“Our paper does support the Warren Buffett-style view that if you buy stocks with low price ratios or low multiples, those generally give higher returns.”— Sean Myers

Sharpening the Returns Debate

According to Myers, what has been strongly documented previously is that firms that have high multiples have high earnings and are very profitable. “However, if your stock price is high relative to your earnings, the only way to justify that is not [merely] by having high earnings, but by actually having increasing earnings,” he said. “You need these earnings to essentially catch up eventually with your price.”

Myers clarified that the findings of earlier studies “are still completely correct” — that high multiple firms do have higher earnings than their peers and higher profitability than their peers. “But they don’t have higher profitability growth or earnings growth than their peers, which still means that their price looks puzzlingly high relative to their earnings,” he said. “That gap is still largely accounted for by differences in returns.”

Takeaways for Investors on Stock Valuation

Myers highlighted the major takeaways from their paper for investors. “So long as you have a long investment horizon, where you buy and hold stocks, our paper does support the Warren Buffett-style view that if you buy stocks with low price ratios or low multiples, those generally give higher returns,” he said. “In fact, those return differences are bigger than we previously thought.”

Another takeaway for investors is to be more skeptical about parking their money in high-multiple firms. “When you see a firm that has a very high multiple, say it’s trading at 50 times earnings or 70 times earnings, do you seriously believe its earnings will triple or quadruple in the next five or six years? [You must] map out what kind of earnings growth would be needed to justify that price. And do you see that happening in previous peers or with comparable peers?”

That extra rigor in inquiry does not rule out exceptional cases. “We’re not saying it’s impossible — particularly individual firms might grow fast enough — but it just looks that on average it’s a bit difficult to justify a lot of these price ratios. Unless there is some massive risk reason why you’re okay paying a lot of money for this firm — even if it will give lower returns — then you may want to rethink where you’re placing your money. You should know when you’re buying the stocks of these very expensive firms that they likely will not grow to the size that will pay off your initial investment.”