I link an asset's risk premium to two characteristics of its underlying cash flow: covariance and duration. Using empirically novel estimates of both cash flow characteristics based exclusively on accounting earnings and aggregate consumption data, I examine their dynamic interaction in a two‐factor cash flow model and find that they are able to explain up to 82% of the cross‐sectional variation in the average returns on size, book‐to‐market, and long‐term reversal‐sorted portfolios for the period 1964 to 2002. This finding highlights the importance of fundamental cash flow characteristics in determining the risk exposure of an asset.

The returns of stocks are partially driven by changes in their expected cashflow. Using revisions in analyst earnings forecasts, we construct an analyst earnings beta that measures the covariance between the cashflow innovations of an asset and those of the market. A higher analyst earnings beta implies greater sensitivity to marketwide revisions in expected cashflow, and therefore higher systematic risk. Our analyst earnings beta captures exposure to macroeconomic fluctuations and has a positive risk premium that provides a partial explanation for the value premium, size premium, and long-term return reversals. From 1984 to 2005, 55.1% of the return variation across book-to-market, size, and long-term return reversal portfolios is captured by their analyst earnings betas.