Stock Market Returns
If you invest in the stock market, you expect that your money will somehow make more money.
But how does this happen?
Where do stock market returns come from?
In theory, the answer is simple.
They come from the same place returns come from if you own a business:
Stock returns come from earnings.
(Earnings is a synonym for profits.)
You can turn this statement into math, like so:
r = E / P
E/P is called the earnings yield; it's the reciprocal of the P/E ratio, expressed as a percent:
The return "r" that the earnings yield predicts is the inflation-adjusted total return (meaning the return from stock price increases, plus dividends).
Sometimes people like to be specific about how the earnings are used:
Stock returns come from the earnings that are distributed to investors as dividends, plus the earnings the company retains and invests in its own growth.
Once again you can turn this into math:
r = (D / P) + G
This is called the Gordon Growth Formula.
D is the dividend per share; D/P is called the dividend yield.
G is the earnings growth rate.
Verifying the Earnings Yield Formula
So far, so logical.
Now let's see if it's right.
The site multpl.com shows that the P/E ratio of the S&P 500 has averaged 15.57.
Take the reciprocal, and you get an earnings yield of 6.42%.
The inflation-adjusted annualized return of the S&P 500 (through 2015) has in fact been 6.86%.
Not a perfect match, but not too shabby, either, for such a simple little model.
It really works!
Long and Short Run
Actually, it only really works over the long run.
Over the short run, P/E ratios tend to stretch away from the average and then snap back toward it,
a process called momentum and mean reversion.
If you invest when P/E ratios are high, then your returns will probably be lower than the earnings yield predicts.
We'll quantify that on the next page.
For now, be aware of this:
Stock returns are the outcome of business realities (like earnings) as well as of market behavior (like P/E).
Business reality tends to dominate over the long run (10+ years);
market behavior can dominate over the shorter run.