The Expected Real Return to Equity

The expected return to equity — typically measured as a historical average — is a key variable in the decision making of investors. A recent literature uses analysts’ forecasts, investor surveys or present-value relationships and finds estimates of expected returns that are sometimes much lower than historical averages. This study extends the present-value approach to a dynamic optimizing framework. Given a model that captures this relationship, one can use data on dividends, earnings and valuations to infer the model-implied expected return. Using this method, the estimated expected real return to equity ranges from 4.9 to 5.6 percent. Furthermore, the analysis indicates that expected returns have declined by about 3 percentage points over the past forty years. These results indicate that future returns to equity may be lower than past realized returns.