Authors: Catherine Georgiou, Vassilis Polimenis

Title: Capturing return variability via the dividend-price-earnings ratio

Abstract

This paper aims to introduce a new predictor of returns based on the long-run equilibrium relationship between dividends, prices and earnings (dpe for short). Our proposed dpe resolves certain econometric issues and enhances predictability findings in return forecasting. We compare results with the classical dividend-price and its modified version (mdp based on the cointegration relationship between dividends and prices). An investor who employs dpe and mdp improves his in-sample forecasts by 49% and 43% respectively at the 10-year horizon, against dividend-price (dp) which interprets merely 22% of time-varying expected returns. Additionally, out-of-sample (oos) performance testing shows that dp fails to generalize well, while mdp proves the strongest oos performer, providing a maximum  of 68.1% when employing the entire sample approach to estimate the trend correction. This study introduces a simple modification in treating dividends, prices and earnings that can be easily replicated by practitioners in the field. The core rationale of our empirical approach along with the resulting findings are strongly associated with market-timing strategies, portfolio and risk management issues that could prove beneficial to investors, researchers and financial analysts, and portfolio managers.