Stock Prices and Future Stock Returns

The PE ratio can be a very misleading indicator of future stock returns in the short run, in the long run, the PE ratio is a very useful predictor.


Current yield of a bond = interest received / price paid
(Current yield of a bond is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.)


Earnings yield of a stock = EPS / price


Since the underlying assets of a firm are real, earnings yield is a REAL, or inflation-adjusted return. Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

This contrasts with the NOMINAL return earned from fixed-income assets (like bonds), where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns. The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%. This earning yield exactly matches the 6.8% real return on equities from 1871.

There are limitations to using the PE ratio to predict future short-term stock returns.

• For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
• And in the short run, there are many other sources of market movement, such as changes in interest rates or the risk premium demanded by stockholders.