Board of Governors of the Federal Reserve System

March 2011

The Expected Real Return to Equity

Missaka Warusawitharana

Abstract:

The expected return to equity--typically measured as a historical average--is a key variable in the decision making of investors. A recent literature based on analysts forecasts and practitioner surveys finds estimates of expected returns that are sometimes much lower than historical averages. This study presents a novel method that estimates the expected return to equity using only observable data. The method builds on a present value relationship that links dividends, earnings, and investment to market values via expected returns. Given a model that captures this relationship, one can infer the expected return. Using this method, the estimated expected real return to equity ranges from 4 to 5.5 percent. Furthermore, the analysis indicates that expected returns have declined by about 2 percentage points over the past forty years. These results indicate that future returns to equity may be lower than past realized returns.

Keywords: Expected returns, production-based models

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