What A Difference A Decade Could Make

What A Difference A Decade Could Make
Stéphane Renevier, CFA

over 2 years ago5 mins

  • Key Takeaways

    • Three factors drive long-term stock returns: dividend yield, earnings-per-share growth, and the change in price-to-earnings ratio
    • Dividend yield and EPS growth tend to contribute positively to returns, but changes in P/E ratios can be positive or negative and tend to have a much bigger impact
    • Given today’s high valuation levels, US stock investors might not get a boost from increasing P/E – so they should look at other regions for higher returns

Key Takeaways

  • Three factors drive long-term stock returns: dividend yield, earnings-per-share growth, and the change in price-to-earnings ratio
  • Dividend yield and EPS growth tend to contribute positively to returns, but changes in P/E ratios can be positive or negative and tend to have a much bigger impact
  • Given today’s high valuation levels, US stock investors might not get a boost from increasing P/E – so they should look at other regions for higher returns

Mentioned in story

After all the upheaval of the last twelve months, you might be tempted to create a stock portfolio that’ll see you through the longer term. So let’s look at what’s historically driven stock market returns over a 10-year period, and what it tells you about how to invest for the next decade…

📈 What influences 10-year returns?

Before we get to where stocks might go in the next ten years, it’s worth knowing the three factors that influence their prices in the long term:

Dividend yield + growth in earnings per share (EPS) + change in price-to-earnings (P/E) ratio = stock returns

Dividend yield is simply how much cash a company pays its shareholders in dividends relative to its stock price. So if a company pays $5 in dividends and its share price is $100, its yield is 5%. That’s the income you’d expect to earn just by holding on to a stock.

The other two factors reflect the capital gains you’d make if you sold the stock at a higher price than you bought.

So say a stock trades at $100 and generates $10 in earnings per share, implying its price-to-earnings ratio is 10. There are two ways you could double your money:

The company’s EPS doubles and its P/E ratio (i.e. its valuation) remains constant

The company’s EPS remains constant, but the P/E ratio doubles (i.e the market is willing to pay twice as much for those same earnings)

You may be wondering why anyone would pay twice as much for the same earnings. Well, it could be that the company’s growth prospects are incredibly high, and that while it doesn’t earn much today, it might in the future. Or it could be that there’s so much demand for the stock that investors are forced to pay a higher price, or just that investors speculate they’ll be able to sell it at an even higher multiple in the future. In other words, it’s not just fundamentals that drive returns, it’s sentiment too.

🥊 What impact have these factors had on 10-year returns?

There’s a lot of variation in stock investors’ real returns over a ten-year horizon. Just look at the chart below, which shows the big swings in the price of the S&P 500 over the past 100 years.

Source: Robert Shiller, Finimize
Source: Robert Shiller, Finimize

Next, take a look at what effect each of our three returns-generating factors – P/E ratio, dividend yield, and EPS growth – have had on the US S&P 500’s 10-year returns in the same period…

Source: CrestmontResearch.com
Source: CrestmontResearch.com

The dividend yield has been the most stable of the three. And while it’s slowly been declining over time, it’s always been (and always will be) positive. Of course, it’s also only contributed returns of about 2% a year over the last decade – much less than the other two factors.

EPS growth can be negative, and it was during the Great Recession of 1929. But it’s almost always been positive otherwise, suggesting companies will usually generate value if given enough time. It’s also been a stable and important driver of returns since the ‘40s, mostly contributing between 4% and 7% a year.

The P/E ratio, meanwhile, has been the bad boy of the bunch, swinging from one extreme to the other. If changes in P/E had worked in your favour, you’d have made returns well above average – more than 10% a year. But if it worked against you, you’d have made 5%-8% less a year. That’s enough to offset both the positive dividend yield and EPS growth, and ultimately transform your returns into a loss.

Put simply, an increase in P/E ratio has been the most important of the three factors in explaining how much money you’d have made or lost over ten years.

🥊 What impact will these factors have on the next 10 years?

Truth is, it’s unlikely that those increases in P/E ratio will drive returns going forward: valuations are already at record highs and unlikely to keep pushing upwards for the next ten years, even if they do in the short term.

So in the best case scenario, valuations won’t rise, but they won’t fall either. That would mean returns could reach 9% a year – a dividend yield of 1-2%, and EPS growth of 7-8%. That’s not bad, but it’s still less than they’ve delivered historically.

If valuations do slip, the outlook is much dimmer: returns might only be 2-4% a year if earnings per share remains unaffected, but it could be as low as -5% a year if – say in the event of a sharp recession – EPS growth is also impacted.

In any case, it seems likely that US stock investors would make lower returns than the (pre-inflation) 10% they’ve made historically. And the experts seem to agree…

Forecasted next 10-year returns. Source: MorningStar, Finimize
Forecasted next 10-year returns. Source: MorningStar, Finimize

💰 So what’s the opportunity here?

If you have a 10-year investing horizon, you should turn these three factors to your advantage: try to identify stocks that have a high dividend yield, high potential for earnings growth, and those that are trading at cheap levels.

Right now, that means favoring “value” stocks in high-yielding sectors – consumer staples and banks, say – over expensive and low-yielding ones, like consumer discretionary and tech. And at a country level, it means going for European and emerging market stocks over American ones.

Of course, it may also pay off just to wait a while – specifically until valuation levels fall to more attractive levels. The extra returns you can make by starting at a better valuation level – and avoiding the drag on your returns caused by falling P/E ratios – might more than offset the opportunity cost of short-term gains.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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