How to Banish Stock Seers with Logic

If you have a good part of your portfolio invested in the stock market, you must have been feeling good for the past few years because the market has been in a steady up trend. Many seers are predicting a continuation of the trend and annual stock market returns of 10% or more per year for many years to come. Is this realistic? Here's how you can judge.

In the long run, returns on individual stocks as well as the stock market as a whole come from only three sources: dividends, earnings growth, and expansion of the price-earnings (P/E) ratio. For foreign stocks there can be a fourth source: weakening of the dollar.

Dividends & Earnings Growth

Let us first understand how dividend and earnings growth contribute to a stock's return by assuming that the P/E of the stock will remain constant at 10.

Suppose you buy a stock whose earnings of $10 per share is neither growing nor contracting and the stock pays a steady annual dividend of $3 per share. The price of the stock will be $100 (ie, $10 earnings multiplied by 10 P/E) and the dividend yield will be 3% per year. Your total return on this stock will be 3% per year—the same as the dividend yield—because if both the earnings and the P/E remain constant, then the price cannot change.

Now suppose the company's earnings grow steadily at 10% per year and the company increases its dividends in line with earnings (ie, at the rate of 10% per year as well). In this case, at the beginning of the next year the stock price will be $110. Why? Because if the earnings go up by 10% to $11 and the P/E remains constant at 10, then the price will go up to $110 (ie, $11 earnings multiplied by 10 P/E) providing a 10% return from price appreciation. The total return you will earn on the stock in the first year will be 13% (ie, 3% from dividend and 10% from price appreciation).

P/E Expansion

The P/E ratio of a stock depends on many factors such as the company's growth prospects, interest rate, and investors' risk appetite. No one can predict what the P/E of a stock will be in the future. If we expect the P/E to go up, then the total return will be higher, and if we expect it to go down, then the total return will be lower.

If in our previous example we assume that the P/E will increase to 11, at the end of the first year the stock price will go up to $121 (ie, $11 earnings multiplied by 11 P/E). This will result in a price appreciation of 21%, which added to the 3% dividend yield will result in a 24% total return for the year.

Estimating Future Returns

Over the long run, stock market earnings have grown in line with the growth of the economy, or about 5% to 6% per year in nominal terms (ie, before adjustment for inflation). From time to time, the growth rates of the earnings and the economy can diverge for a few years, but that most likely is not sustainable.

Add to that earnings growth rate the current dividend yield of the stock market, which is about 2%, and we get an expected total long-term return for the stock market of about 7% to 8% per year.

Can we expect any contribution from P/E expansion? Not much. The market's P/E ratio is currently close to its historical average.

So, next time a guru predicts a 15% per year long-term return for stocks, ask them where it is going to come from. In the meantime, do not cut back your savings for retirement counting on the higher returns you keep hearing about. Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.