This paper by Tuomo Vuolteenaho examines the factors driving firm-level stock returns using a vector autoregressive (VAR) model. The study decomposes stock returns into two components: changes in cash-flow expectations (cash-flow news) and changes in discount rates (expected-return news). The main findings are: 1. **Cash-Flow News Dominates**: Firm-level stock returns are primarily driven by cash-flow news. For excess log returns, the variance of expected-return news is about half that of cash-flow news. For market-adjusted log returns, the variance of expected-return news is one-fifth that of cash-flow news. 2. **Correlation Between News Components**: Cash-flow news and expected-return news are positively correlated for typical small stocks, with the correlation being largest for the smallest stocks and declining monotonically with stock size. 3. **Diversification of Cash-Flow News**: Cash-flow news can be diversified away in aggregate portfolios, while expected-return news is largely firm-specific. For an equal-weight portfolio, the variance of cash-flow news is only three-quarters of the variance of expected-return news. The paper also discusses the implications of these findings for market behavior, such as underreaction to cash-flow news in small stocks and the role of systematic, macroeconomic components in expected-return news. The results are consistent with previous literature on aggregate stock returns, suggesting that while cash-flow information is more idiosyncratic, expected-return information is driven by broader market factors.This paper by Tuomo Vuolteenaho examines the factors driving firm-level stock returns using a vector autoregressive (VAR) model. The study decomposes stock returns into two components: changes in cash-flow expectations (cash-flow news) and changes in discount rates (expected-return news). The main findings are: 1. **Cash-Flow News Dominates**: Firm-level stock returns are primarily driven by cash-flow news. For excess log returns, the variance of expected-return news is about half that of cash-flow news. For market-adjusted log returns, the variance of expected-return news is one-fifth that of cash-flow news. 2. **Correlation Between News Components**: Cash-flow news and expected-return news are positively correlated for typical small stocks, with the correlation being largest for the smallest stocks and declining monotonically with stock size. 3. **Diversification of Cash-Flow News**: Cash-flow news can be diversified away in aggregate portfolios, while expected-return news is largely firm-specific. For an equal-weight portfolio, the variance of cash-flow news is only three-quarters of the variance of expected-return news. The paper also discusses the implications of these findings for market behavior, such as underreaction to cash-flow news in small stocks and the role of systematic, macroeconomic components in expected-return news. The results are consistent with previous literature on aggregate stock returns, suggesting that while cash-flow information is more idiosyncratic, expected-return information is driven by broader market factors.