Stock Return Variation and Expected Dividends : A Reinterpretation

Kothari and Shanken (1992) argue that stock return variation can, to a large extent, be explained by rational revisions of future dividend expectations. Kothari and Shanken arrive at this conclusion based on the explanatory power of a regression of returns on lagged dividend yield, contemporaneous and future dividend growth rates, and future returns. This regression nests a truncated, first order approximation of the definition of return. Hence, the explanatory power is high by construction and has only minimal economic interpretations. Our reinterpretation has implications for other studies that use future variables to explain past returns. The explanatory variables are difficult to interpret, and these models may misidentify the main source of return variation. By decomposing the regressions, we clarify the roles of the explanatory variables