Tuesday, September 22, 2009

Evaluating Equities

While the days of buy and hold may be over, below is a simplified way to think about forecasting equity returns over the long haul that I've found useful. I'll walk through the methodology, show some supporting charts, then detail my expectations for the equity asset class over the mid-to-long term. I'd love to hear all of your thoughts.

Equity Returns: In Theory
The earnings of a company are what you own as an investor and earnings are paid out to investors through dividends. Another way to say this is that the value of a company is the present value of all future dividends. Thus, equity returns = dividend (or corporate earnings) growth + the dividend yield (what isn't returned to an investor in the form of a dividend now, is reinvested, and grows at that same growth rate as earnings).

Quick and Dirty Estimation of Earnings Growth
A quick and dirty way that has been used to forecast future equity returns is to use nominal GDP growth as a substitute for earnings growth because in theory, earnings growth should be roughly equal to the growth of the economy. The reason why this is quick and dirty is because it is just that... quick and dirty. So dirty in fact, that it is wrong. Over the past 60 years, earnings (and thus dividend) growth of S&P 500 companies hasn't kept up with that of the broader economy (AND has recently taken a massive dive). Want an even quicker and dirtier method? Assume 6% (see here).

Historical Data
Below is a chart showing just that, the growth of the economy and that of both earnings and dividends.

Click for Giant Chart...

In theory, since the growth rate of dividends and earnings have been lower than that of nominal GDP, the S&P 500 should have underperformed the nominal growth rate of equities ex dividends. However, as the chart below shows, just the opposite has occurred as investors have flocked to the asset class (think 401k's and baby boomers) driving up the price to earnings ratio (i.e. the price individuals are willing to pay for each $1 of earnings) since 1949.

Equity Forecast
Forecasts should never be thought of as an exact science, but rather a framework based upon assumptions that can / will change frequently. That said, using the quick and dirty method as a starting point, I'd go with 2.5% long-term GDP growth (in real terms) with 2% inflation to get nominal economic growth at 4.5% (low, yes). Add to that the 2.5% current dividend yield and we get a 7% long-term return for equities as an asset class. BUT, based on the data I presented above, I'd reduce this by roughly 1% as dividends have underperformed nominal GDP to get a 6.0-6.5% outlook over the long-term. Less fees associated with transacting (hat tip MAB) and I'll reduce this to 5.5%-6.0% for the broader investment community.

Of course there are scenarios that could play out over both the near-term (continued P/E compression from strong flows into the asset class) and long-term (economic growth reverting back to the long-term mean faster than I suspect) that would mean higher returns, but there are also plenty of surprises that may happen to the downside (one specifically being the possibility of the P / E ratio trending lower in coming years).


Source: Irrational Exuberance / BEA