What determines the returns from stocks?

Very long-run returns from common stocks are driven by two critical factors:

1.  the dividend yield at the time of purchase, and,
2.  the future growth rate of earnings and dividends.

In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the "present" or "discounted" value of its stream of future dividends.

A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.

Even is a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to:

1.  a more rapidly growing stream of dividends in the future or
2.  alternatively to greater earnings that can be used by the company to buy back its stock.

The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula for the long-run total return for either an individual stock or the market as a whole:

LONG-RUN EQUITY RETURN
= INITIAL DIVIDEND YIELD + GROWTH RATE




From 1926 until 2010:

Common stocks provided an average annual rate of return of about 9.8%.
DY for the market as a whole on Jan 1, 1926 was 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
DY + Growth rate gives a close approximation of the actual rate of return.


Over shorter periods

Over shorter periods, such as a year or even several years, a third factor is critical in determining returns.
This factor is the change in valuation relationships, namely, the change in the price-dividend or price-earnings multiple.
[P/Div and P/E tend to move (increase or decrease) in the same direction.]


Ref: A Random Walk Down Wall Street

Valuing Stocks - What Is a Stock's Value?

The value of most stocks is a combination of the current value of the company and the value of the profits it will make in the future.

In general, the more growth the market expects from a company, the more the company's market value will owe to expected future profits.  

Take online bookseller YY, for example.  By most measures, company YY has little or no current value; it has only minuscule book value and is gushing red ink.  Liquidating company YY would leave its investors with zilch.  But the market thinks the company's future profit potential is so bright that it has pinned a multibillion-dollar worth (the company's market capitalization) on the stock.

Another way to think of a stock's value is that a company's stock price consists of a combination of what you are paying for the company's current level of profitability and what you're paying for its earnings growth.

Since company YY is far from profitable then,  the stock price is based almost entirely on expectations of future growth.  That is one reason company YY's stock is so volatile.

As those expectations rise and fall, so does the price of its stock.

In comparison, the stock price of another stock XX largely reflects the company's current value, not its future growth.  Company XX is quite profitable, but no one expects it to grow terribly fast.

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.