Another one of those phrases that gets tossed around a lot is “stock market returns.” Obviously, stock market returns are an expected part of both trading and investing. Returns, after all, represent profit (or loss).
But where do those returns really come from? How does it all happen?
Earnings, aka “profits” are where returns originate. In mathematical terms, Returns are the result of dividing earnings (per share) by price (per share). This is the inverse of P/E ratio and is known as the E/P ratio.
Stock returns are created by the earnings distributed as dividends plus the earnings the company keeps and invests in growth. Known as the Gordon Growth Formula it looks like this: r = (D/P) + G. Returns equals (D)ividend per share divided by (P)rice per share plus earnings (G)rowth rate.
It Can Get Messy
The formulas and your understanding of them really work best over the long run. Over the short run, P/E ratios tend to stretch away from the average and then snap back toward it. This process is called momentum and mean reversion.
What it means is this: If you invest when P/E ratios are high, your returns will probably be lower than predicted. Basically, business reality tends to dominate over the long run (10+ years); market behavior can dominate over the shorter run.
Components Of Stock Market Performance
Two respected authors, Jack Bogle and William Bernstein say there are three main components to long-term stock market performance: Dividend Yield, Earnings Growth and Changes in P/E Ratio.
It makes sense. Dividends are a percentage or amount. Earnings growth rate should correlate with share price. If the growth rate is 5%, the price of a share should rise by 5%. Add those two parts together and you have the Fundamental Return.
Finally, P/E ratio represents how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings and annual earnings are $4, then the share price should be $80. This part, represented by changes to the P/E ratio is known as Speculative Return. Finally, total return is equal to fundamental return plus speculative return.
Related: STANDARD & POOR’S 500 INDEX
Predicting Fundamental and Speculative ReturnEssentially, fundamental return is based on GDP growth which is connected to population growth and productivity. If you believe GDP will continue to increase over time, chances are fundamental return will increase as well.
Speculative return has contributed greatly to high returns over the past 25 years for the S&P 500. Analysts believe this is due to an increase in the overall P/E ratio of the stock market. In 1950 P/E was 7. During the dot-com bubble it was over 40. Recently is has been as high as 24. Most experts don’t believe it will achieve the heights of the dot-com bubble. If it stays flat or falls, ultimately this will lead to a flat or even negative future speculative return.