Earnings, Dividends and Returns: A Theoretical Model

In this paper we develop a theoretical model to explain raw returns and abnormal returns. We show that returns can be explained in terms of levels and changes in earnings and dividends. This contrasts with empirical work which typically uses only a subset of these variables. The model also explains cross-sectional variation in coefficients on earnings variables in terms of company specific characteristics such as the firm's target payout ratio. The model provides a theoretical explanation of the "anomalous" results of Easton and Harris (1991) who demonstrate empirically that both earnings levels and changes jointly explain returns. Additionally, we suggest that single equation studies are likely to be of limited value in empirically investigating the relation between earnings and returns, particularly where such equations are estimated in cross section, and the coefficients are constrained to be constant over all firms.