II. THE SIX METHODS FOR DECOMPOSING HISTORICAL EQUITY RETURNS

Yale ICF Working Paper No. 00-44

March 2002

STOCK MARKET RETURNS IN THE LONG RUN:

PARTICIPATING IN THE REAL ECONOMY

Roger G. Ibbotson

Yale School of Management

Peng Chen

Ibbotson Associates, Inc.

This paper can be downloaded without charge from the

Social Science Research Network Electronic Paper Collection:

http://papers.ssrn.com/abstract=274150

Stock Market Returns in the Long Run:

Participating in the Real Economy

Roger G. Ibbotson, Ph.D.

Professor in the Practice of Finance

Yale School of Management

135 Prospect Street

New Haven, CT 06520-8200

Phone: (203) 432-6021

Fax: (203) 432-6970

Chairman

Ibbotson Associates, Inc.

225 N. Michigan Ave. Suite 700

Chicago, IL 60601-7676

Phone: (312) 616-1620

Fax: (312) 616-0404

Peng Chen, Ph.D., CFA

Vice President, Director of Research

Ibbotson Associates, Inc.

225 N. Michigan Ave. Suite 700

Chicago, IL 60601-7676

Phone: (312) 616-1620

Fax: (312) 616-0404 E-mail: pchen@ibbotson.com

March 2002

Stock Market Returns in the Long Run

ABSTRACT

We estimate the forward-looking long-term equity risk by extrapolating the way it participated in the real economy. We decompose the 1926-2000 historical equity returns into supply factors including inflation, earnings, dividends, price to earnings ratio, dividend payout ratio, book value, return on equity, and GDP per capita. There are several key findings: First, the growth in corporate productivity measured by earnings is in line with the growth of overall economic productivity. Second, P/E increases account for only a small portion of the total return of equity (1.25% of the total 10.70%). The bulk of the return is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth). Third, the increase in factor share of equity relative to the overall economy can be more than fully attributed to the increase in the P/E ratio. Fourth, there is a secular decline in the dividend yield and payout ratio, rendering dividend growth alone a poor measure of corporate profitability and future growth. Contrary to several recent studies, our supply side model forecast of the equity risk premium is only slightly lower than the pure historical return estimate. The long-term equity risk premium (relative to the long-term government bond yield) is estimated to be about 6% arithmetically, and 4% geometrically. Our estimate is in line with both the historical supply measures of the public corporations (i.e., earnings) and the overall economic productivity (GDP per capita).

¹ Stock Market Returns in the Long Run

I. INTRODUCTION

Numerous authors are directing their efforts toward estimating expected returns on stocks incremental to bonds.¹ These equity risk premium studies can be categorized into four groups based on the approaches they have taken. The first group of studies try to derive the equity risk premiums from historical returns between stocks and bonds as was done in Ibbotson and Sinquefield (1976a,b). The second group, which includes our current paper, uses fundamental information such as earnings, dividends, or overall economic productivity to measure the expected equity risk premium. The third group adopts demand side models that derive expected equity returns through the payoff demanded by investors for bearing the risk of equity investments, as in the Ibbotson, Siegel, and Diermeier (1984) demand framework, and especially in the large body of literature following the seminal work of Mehra and Prescott (1985). The fourth group relies on opinions of investors and financial professionals through broad surveys.

Our paper uses supply side models. We first used this type of model in Diermeier, Ibbotson, and Siegel (1984). There have been numerous other authors who have also used supply side models, usually focusing on the Gordon (1962) constant dividend growth model. For example, Siegel (1999) predicts that the equity risk premium will shrink in the future due to low current dividend yields and high equity valuations. Fama and French (2002) use a longer time period (1872 to 1999) to get geometric equity risk premiums of 2.55% using dividend growth rates, and 4.32% using earnings growth rates.² Campbell and Shiller (2001) argue for low returns, because they believe the current market is overvalued. Arnott and Ryan (2001) argue that the forward-looking equity risk premium is actually negative. This stems from using the low current dividend yield plus their very low forecast dividend growth. We later argue that mixing the current low dividend yields and payout ratios with historical dividend yield growth violates Miller and Modigliani (1961) dividend theory.

The survey results generally support somewhat higher equity risk premiums. For example, Welch (2000)

conducted a survey among 226 academic financial economics on equity risk premium expectations. The

² Stock Market Returns in the Long Run

survey shows that the geometric long horizon equity risk premium forecast is almost 4%.³ Graham and Harvey (2001) conducted a multi-year survey of CFOs of U.S. corporations, they find that the expected 10-year geometric average equity risk premium ranges from 3.9% to 4.7%.

In this paper, we link historical equity returns with factors commonly used to describe the aggregate equity market and overall economic productivity. Unlike some studies, our results are portrayed on a per share basis (per capita in the case of GDP). The factors include inflation, earnings per share, dividends per share, price to earnings ratio, dividend payout ratio, book value per share, return on equity, and GDP per capita.⁴ We first decompose the historical equity returns into different sets of components based on six different methods. Then, we examine each of the components within the six methods. Finally, we forecast the equity risk premium through supply side models using historical data.

Our long-term forecasts are consistent with the historical supply of U.S. capital market earnings and GDP per capita growth over the period 1926-2000. In an important distinction from the forecasts of many others, our forecasts assume market efficiency and a constant equity risk premium.⁵ Thus the current high P/E ratio represents the market’s forecast of higher earnings growth rates. Furthermore, our forecasts are consistent with Miller and Modigliani (1961) theory so that dividend payout ratios do not affect P/E ratios and high earnings retention rates (usually associated with low yields) imply higher per share future growth. To the extent that corporate cash is not used for reinvestment, it is assumed to be used to repurchase a company’s own shares or perhaps more frequently to purchase other companies’ shares. Finally, our forecasts treat inflation as a pass-through, so that the entire analysis can be done in real terms.

II. THE SIX METHODS FOR DECOMPOSING HISTORICAL EQUITY RETURNS

We present six different methods of decomposing historical equity returns. The first two methods

(especially method 1) are models based entirely on historical returns. The other four methods are models

³ Stock Market Returns in the Long Run

of the supply side. We evaluated each method and its components by applying historical data from 1926 to 2000. The historical equity return and earnings data used in this study are obtained from Wilson and Jones (2002).⁶ The average compounded annual return for stock market over the period 1926-2000 is 10.70%. The arithmetic annual average return is 12.56% and the standard deviation is 19.67%. In as much as our methods use geometric averages, we focus on components of the geometric return (10.70%). Later in the paper when we do our forecasts, we convert geometric average returns to arithmetic average returns.

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