What Explains Long-Term Returns?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 23, 2017 3:29:10 PM

and tagged Investing

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returnsWe concluded yesterday that time, in and of itself, does not explain how investments should behave over the next several years. The question now, of course, is what does?

Back to fundamentals

In essence, when you buy an investment, you are buying two things: a stream of income while you own it, and the sale price when you sell it. The price you pay will depend on how much income you are getting and how you expect the price to change while you own it. Different investors value each component differently, but that is the mathematical and financial basis of any investment.

Although time does not come into this, cash flows and appreciation do. To isolate the problem, let’s consider several identical investments—say, shares of stock in a company. They are exactly the same, produce the same income, and will sell for the same price at the same time. If several investors bought these shares, what would determine how their investments did?

The only answer is price. Other things being equal, buying cheaper yields better returns.

Price as a driver of returns

Suppose you have a company that you know will sell for $100 per share in one year, and that you will get $5 in dividends during that year. If you pay $100 for the share, you get a return of $5 total, or 5 percent. If you pay $90 per share, you get $15 in return ($5 dividend plus $10 appreciation) for a 16.67-percent return (15/90). If you pay $105 per share, you make no money, as the dividend is offset by the capital loss. The lower the price, the higher the return.

You can extend this argument to the stock market as a whole by using the price/earnings ratio. This is simply the total share prices of the stocks divided by the earnings per share. The P/E ratio can also be expressed as the E/P ratio, the earnings divided by the price, also known as the earnings yield. So, for example, with a stock price at $100 and earnings at $5, the P/E would be 20 (100/5) and the earnings yield would be 5 percent (5/100). If the company paid out all its earnings to shareholders, you would get a return of 5 percent per year.

This brings us back to price and actual returns. The earnings return is determined by the earnings and the price you pay. In other words, if you paid $200 for the above share, your return would be 2.5 percent. So higher prices immediately equate to lower returns. The same also applies to the capital return. Other things being equal, the higher the price you pay, the less gain you get for any future price. Buying high therefore means lower returns on both components, unavoidably.

Note that this applies no matter what happens with earnings growth. Yes, you might make money at a higher price, but less so than if you bought at a lower price. Price ultimately determines your returns.

Closer to a solution

Now we’re back to where we started, but this time with an answer. The price we pay determines, over time, how well we will do with our investments. For the market as a whole, we can express this price as how much we are paying in relation to current earnings.

In theory, we should be able to use this information to better match our estimates of future returns with reality. Time will still come into it, as we will see, but the starting point will be price. We’ll take a look at how this works tomorrow.

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