Hat tip to Jake Taylor (one of the hosts of the Value: After Hours podcast and an exceptionally smart/grounded person), for the inspiration behind today’s post.
TL;DR Summary
Expectations by individual investors are unrealistically high (as much as 17.5% per year long-term returns ABOVE inflation in the US). Those by financial advisors are much more reasonable, although possibly still optimistic.
Returns are driven by cash flows returned to investors in the form of dividends, growth in the firm’s underlying business in the form of a metric such as earnings per share, and changes in the multiple investors are willing to pay for said metric.
Using EPS growth in the S&P 500 from 2010 - 2019, the current dividend yield, current inflation expectations, and a forward multiple of 22.5 (which is the current multiple), we would get a real return of 3.4% over the next 9 years.
To get 17.5% returns above inflation, we need EPS growth to average 8% per year and the forward multiple to grow to 52 times next year’s EPS.
Investors would need to be able to display superior stock-selection skill (which is more difficult than most would expect) in order to generate real returns above the low-to-mid single-digit range.
This does not mean to sell your stocks, merely a recommendation to adopt more reasonable expectations going forward.
A few weeks ago, I cited a study by Natixis on global investor expectations. The results were eye-opening (maybe even eye-popping).
Here are a couple of the highlights:
Globally, individual investors expect long-term returns on equities above inflation of 14.5%, while financial professionals are predicting 5.3% returns.
In the US, individual investors expect long-term returns on equities above inflation of 17.5%, while financial professionals are predicting 6.7% returns.
The returns above inflation have grown gradually each year (except for a slight dip in 2016) from 8.9% above inflation to 10.7% in 2019…then jumped to 13.0% in 2021.1
The survey (at least based on what I saw) does not specify some details which would be helpful. Given that, I’m going to make some assumptions. First, long-term is not specified. It could be 5 years, 10 years or even longer. I’m going to assume 9 years which will take us to 2030. Second, the asset classes of investors’ portfolios are not mentioned. These could include individual stocks, mutual funds, bonds, real estate, and even cryptocurrencies/art/etc. I’m going to focus on equities. Third, it doesn’t mention whether these are being held in tax-sheltered accounts or not.2 For simplicity, I’m going to assume tax-sheltered accounts.
Where Do Returns Come From?
For equity investors, there are three basic sources of returns.
Current cash distributions (these are typically dividends, but over the past 30 years have also increasingly included stock buybacks)3;
Growth in earnings (or cash flows, EBITDA, or some other measure of profitability); and
Change in valuation multiple.
Let’s start with the first basic source of returns. When students learn about stock valuation, it typically starts with the idea that the value of a stock is equal to the present value of all dividends that the firm is expected to pay out over its lifetime.4 For tax reasons and investor flexibility, many companies supplement dividends with stock buybacks (which reduce shares outstanding and increase the fractional ownership of shareholders who don’t sell). In my analysis, I’m going to just go with the current dividend yield (as buybacks will enhance growth rates slightly).
Next, we have growth in earnings (or other metrics of profitability). It could be growth in Earnings Per Share (EPS), growth in Free Cash Flows (FCF), growth in Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), or even Revenues. Essentially, whatever metric you want to use for terminal value. For data availability, let’s go with EPS.
Finally, you have your capital gains, which is the difference between what you paid today and what you can sell the asset for later. The easiest way to estimate this is with a multiple of the earnings metric used above. For example, if you are using S&P 500 EPS, you would use the PE multiple. If you were using S&P 500 FCF, you would use a P/FCF multiple. These multiples have a lot of variance from company to company based on risk, growth rates, etc. Therefore, it’s a blunt instrument. However, if we buy the S&P 500 at a PE of 25 and EPS for the S&P is 100, we would be paying $2500. If we then sell when EPS is 200 and the PE is 30, we are selling for $6000. Assuming there was a 9-year time frame, this would generate a return of 10.22%. If the current dividend yield is 2% (and we assume it stays there), that would raise our return to 12.22%. If inflation over that time period averages 1%, then our return above inflation would be 11.22%.
What Has to Happen to Get 17.5%?
If we think of a stock as a fractional ownership share in a business (which it is), then it makes sense that the value of the stock should be connected to the value of the underlying business. While it is impossible to know what the true value of the business is, it is reasonable that, all else equal, the more the stock price rises, the worse the potential return is going forward. The more the stock price falls, the better the potential return.5 However, this is not what tends to happen (at least in the short-run) in the investments world. Instead, we see momentum, which argues that investments that have outperformed in the recent past are more likely to outperform in the near future. Given the incredible performance of equities since the COVID bottom in March 2020 (the S&P 500 has returned about 100% since March 23, 2020, the NASDAQ 100 has done even better with a 115% return, and some individual stocks like Tesla have returned about 850%), it is easy to see why investors have some high expectations going forward. However, are those expectations reasonable?
Let’s start with the Twitter post that inspired this week’s newsletter.
Let’s start with Jake’s math. If the S&P 500 is 4400 (it’s 4395 as I type on July 31st, 2021) and current earnings per share forecast for 2021 are $195, that gives us a current PE of 22.5.6 If we look at earnings growth from 2010 - 2019 for the S&P 500, we get 4.4%. Let’s assume that holds. The current dividend yield is 1.3%. Expected inflation is expected to be 2.3% going out to 2030. Given all that, let’s run the numbers out to 2030 (9 years from now). If the EPS keeps growing at 4.4% per year, we would get a forecasted EPS of $2877. Multiply that by a PE of 22.5 and we get the S&P at 6458. Thus, our capital gains will be 4.4%, our dividend yield will be 1.3%, and we’ll lose 2.3% to inflation for a total average annual return of 3.4%. A bit short of the 17.5% expectations (and even quite a bit short of the 6.7% from finance professionals).
What needs to happen to get a 6.7% return? Either we’ll need to see higher earnings growth or the PE multiple will need to expand. If we get 6% earnings growth average, that should get our forecasted EPS up to $330 and we need to get the S&P up to 8578 (assuming the same dividends and inflation), so the multiple will need to grow to 26. Based on that, we earn a 7.7% return, add in our 1.3% dividend yield to get us to a 9% return, then take out the 2.3% inflation to drop us back down to 6.7% return above inflation.
What about getting to a 9% return. We’ll start by assuming earnings grow at 7% per year (note that GDP is expected to be about 2% to 2030, so that has earnings growing at 3.5X GDP growth). That will give us a forecasted EPS of $359 and we will need the S&P to grow to 10,375 for a PE of 28.9. That gets us a 10.0% capital gains, add in our 1.3% dividend yield to get us to an 11.3% return, then take out the 2.3% inflation to drop us back down to 9% return above inflation.
Finally, let’s go all the way up to the 17.5% return. Now, I’ll raise my EPS growth to 8% per year (4X GDP growth). This will give us forecasted EPS of $390 and we will need the S&P to grow to 20,273 for a PE of 52. Note that this requires (a) earnings growth to almost double from what it’s been the past decade (prior to COVID) and (b) the forward PE to more than double from its current level. This seems…what’s the word…optimistic.
Here is a little table with approximate returns (I say approximate because there are far too many moving parts to get this accurate…think of it as a ballpark estimate) over the next 9 years given various growth rates in EPS and forward PE multiples for the S&P 500 (and note that both of these may be generous as the 10-year average EPS growth from 2010-2019 was 4.4% and the 20-year average forward PE multiple through February 2020 was 15.5).
Note that the middle square in this chart is essentially a 6% return above inflation (which really is not that bad). Since 1928, the S&P 500 total return has been about 7% above inflation.
Final Thoughts
One consideration is that these numbers represent returns to the S&P 500. If you exhibit superior stock selection, you may outperform these numbers. Of course, the flip side is that if you exhibit INFERIOR stock selection, you will underperform these numbers. Unfortunately, evidence suggests that the average individual is more likely to fall in the second camp over time than the first (due to overtrading, taxes, transaction costs, value of time, behavioral biases, etc.). This does not mean that you should get out of stocks at the moment. Merely that it would be wise to temper your expectations.
This is a one-year forecast for 2021 vs. the 14.5% which is a long-term forecast.
While taxes are not mentioned in the return portion, they came in as the second biggest concern (and were first for US investors).
The discussion of buybacks as a dividend substitute may show up in a future post. It is important to note that by using EPS as our metric of firm growth, we are controlling for buybacks. This is because buybacks will reduce the shares outstanding so that even on the same level of net income, EPS will grow. Consider a firm with 100 million shares outstanding and $100 million in net income. Their EPS will be $1. If they buy back 10 million shares, their EPS will grow to $1.11 per share.
We’ll ignore for a second the absurdity of assuming that an investor knows (a) the exact dividend payment stream for the company over its lifetime including both how much and how long and (b) that investors know the appropriate discount rate to use. Changes to either of these can have a pretty significant impact on valuation. Plus there are companies like Berkshire Hathaway (among others) who, despite significant profitability over the years, has chosen to reinvest cash flows for strategic reasons. Us academics have a penchant for some unrealistic assumptions.
“All else equal” is a classic academic cheat code (just like a running QB is for those that play fantasy football) as all else is never equal. We live in a dynamic world and there are hundreds of moving parts within the firm, with the regulatory environment, technology, competition, economy, etc. It is quite possible that the price goes up by 5% and the underlying business value went up by 10%, which would actually increase potential returns. Investing is complicated!
Note that the EPS is a bit tricky. You can get historical data, but (especially given the last year), that may not be as meaningful as we’d like. It looks like this is what Jake used and is probably a bit too low due to COVID numbers in 2020. Using the current year (which is not yet finished) requires estimates…and estimates will vary. In this analysis, I used data from Yardini Research which had a forecast of $195 for 2021. The SPY (S&P 500 ETF) shows a 1-year ahead PE of 22 which would be equivalent to a forecast of $200 on the S&P 500.
To get the future EPS 9 years out, I’m using a simple future value calculation at the rate of return. In other words, EPS9 = $195*(1 + 0.044)^9 = $287.