of these measure the market value ofthe shares outstanding relative to economic fundamentals, such as earnings, dividends, or book values, or to some economic aggregate, such asthe gross domestic product (GDP) or total replacement cost of the capital stock. Stock prices are often said to be “high” if these ratios exceedtheir historical average value. Yet one has to be very careful when exercising this judgment. The following are a set of commonly used valuation measures.
Price-Earnings RatiosThe most basic and fundamental yardstick for valuing stocks is the priceearnings ratio. The price-earnings ratio (or P-E ratio) of a stock is simplythe ratio of its price to its annual earnings. The price-earnings ratio of themarket is the ratio of the aggregate earnings of the market to the aggregate value of the market. The P-E ratio measures how much an investoris willing to pay for a dollar’s worth of current earnings.The single most important variable determining the P-E ratio for anindividual stock is the expectation of future earnings growth. If investors believe future earnings growth is going to be high, they will payat a higher P-E ratio than they will pay if they expect earnings to stagnate or decline. But earnings growth is not the only factor influencingthe P-E ratio. P-E ratios are also influenced by other factors such as interest rates, risk attitudes of investors, taxes, and liquidity.The P-E ratio of the entire market, based on the most recent 12months of reported earnings, is shown in Figure 7-2. It has fluctuated between a low of 5.31 in 1917 and a high of 46.71 in 2002. Its average historical level is 14.45.The very high number recorded for 2002 is due to very special circumstances. It is not the “bubble” in market prices that prevailed at theend of the last century. Instead, as we will discuss in the next chapter, it isrelated to the collapse in reported earnings caused by a few technology
CHAPTER 7 Stocks: Sources and Measures of Market Value
FIGURE
111
7-2
Historical P-E Ratios Based on the Last 12 Months of Reported Earnings, 1871 through December 2006
firms, such as JDS Uniphase and AOL, that took huge write-offs relatedto overpriced stocks that were purchased at the height of the bubble.
P-E Ratios and Future Stock ReturnsAlthough the P-E ratio can be a misleading indicator of future stock returns in the short run, in the long run the P-E ratio is a very useful predictor. The reasons may be understood by analyzing how stock andbond returns are calculated.The current yield of a bond is the ratio of the interest received overthe price paid, and it is a good measure of future return if the bond is notselling at a large premium or discount to its maturity value. A similarcomputation can be made with stocks by computing the earnings yield,which is the earnings per share divided by the price. The earnings yield
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is the inverse of the price-earnings ratio, and it would be the currentyield on a stock if all earnings were paid out as dividends.25Since the underlying assets of a firm are real, the earnings yield is areal, or inflation-adjusted, return. Inflation raises the prices of the outputand hence the cash flows from the underlying assets. As a result real assets tend to rise in value when the price level increases. The increasingcash flow from equities contrasts to the fixed return earned from bonds,where the coupons and the final payment are fixed in money terms anddo not rise with inflation.The long-run data certainly bear out this contention. As notedabove, the average historical P-E ratio has been 14.45, so the averageearnings yield on stocks has been 1/14.45, or 6.8 percent. This earningsyield is virtually identical to the 6.7 percent real return on equities from1871 taken from Table 1-1.When using the earnings yields to predict forward-looking real returns, it is advisable to take some average of past earnings to smooth outtemporary increases and decreases in earnings that may be due to suchfactors as the business cycle. The earnings yield based on a five-year average of past earnings against the next five years of real returns is plotted in Figure 7-3.Although there is significant noise in the data, the plot does show asignificant relation between earnings yields and subsequent returns. Thevery high earnings yields (and low P-E ratios) of over 0.2 were associated with the highest subsequent five-year returns, while the two lowestearnings yields (and highest P-E ratios) of 0.0291 and 0.0293 are associated with low subsequent returns. Almost one-quarter of the subsequentfive-year returns can be explained by the earnings yields.But one must be very careful about using a historical average ofearnings. Although such a procedure will remove some of the cyclicalbias in the data, it is not robust to changes in dividend yield policy. Asnoted in Chapter 3 in discussing the trend line of the Dow Jones Industrials, and as will be discussed in the next chapter, a change in dividendpolicy will change the rate of earnings growth so that average earningsyields are not directly comparable. A fall in the payout ratio, which accelerates capital gains, will lead to an underestimate of future real returnsif an average of past earnings is used.
25If all earnings are not paid as dividends, then the return on the stock will be the sum of the dividend yield plus the capital gain, which, under the assumptions about the invariance of the value ofthe firm to the dividend policy noted earlier, will equal the earnings yield on the stock.
CHAPTER 7 Stocks: Sources and Measures of Market Value
FIGURE
113
7–3
Plots of the Earnings Yields Based on a Five-Year Average of Past Earnings, January 1876 throughDecember 2001, versus the Next Five Years of Real Returns
The Fed Model, Earnings Yields, and Bond YieldsIn early 1997, in response to Federal Reserve Chairman AlanGreenspan’s increasing concern about the impact of the rising stockmarket on the economy, three researchers from the Federal Reserve produced a paper entitled “Earnings Forecasts and the Predictability ofStock Returns: Evidence from Trading the S&P.”26 This paper documented the remarkable correspondence between the earnings yields onstocks and the 30-year government bond rates.Greenspan supported the results of this paper and suggested thatthe central bank regarded the stock market as “overvalued” whenever26Joel Lander, Athanasios Orphanides, and Martha Douvogiannis, “Earnings Forecasts and the Predictability of Stock Returns: Evidence from Trading the S&P,” Federal Reserve, January 1997.Reprinted in the Journal of Portfolio Management, vol. 23 (Summer 1997), pp. 24–35. It refers to an earlier version that was presented in October 1996.
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this earnings yield fell below the bond yield and “undervalued” whenever the reverse occurred. The analysis showed that the market wasmost overvalued in August 1987, just before the October 1987 stock market crash, and most undervalued in the early 1980s, when the great bullmarket began.The basic idea behind the Fed model is that bonds are the chief alternative for stocks in investors’ portfolios. When the bond yields rise abovethe earnings yields, stock prices fall because investors shift their portfolioholdings from stocks to bonds. On the other hand, when the bond yieldsfall below the earnings yields, investors shift to stocks from bonds.Figure 7-4 shows that the Fed model appeared to work fairly well beginning in 1970. When interest rates fell, stocks rallied to bring the earnings yields down, and the opposite occurred when interest rates rose.What is surprising is that this relation held despite the fact thatstocks and bonds are very different assets. Government bonds haveironclad guarantees to pay a specified number of dollars over time butbear the risk of inflation. Stocks, on the other hand, are real assets whoseprices will rise with inflation, but they bear the risk of the uncertainty ofFIGURE
7–4
Fed Model of Stock Market Valuation, 1926 through December 2006
CHAPTER 7 Stocks: Sources and Measures of Market Value
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earnings. The reason why the Fed model worked is that the market ratedthese two risks as approximately equal during this period.There is no question that both bonds and stocks do badly when inflation increases. Bond prices fell in the late 1960s and 1970s because rising inflation forced interest rates up to offset the depreciating value ofmoney. Stocks fall during inflationary periods for other reasons, such aspoor monetary policy, low productivity, and a tax system that is onlypartially indexed to inflation. These are detailed in Chapter 5.But these two risks are not equal when inflation is low or when deflation threatens. In those circumstances, bonds (especially U.S. government bonds) will do very well, but deflation undermines firms’ pricingpower and is bad for corporate profits. Figure 7-4 shows that before inflation became a major concern in the 1970s, there was no relation between bond yields and earnings yields and the Fed model broke down.In order to put stock and bond valuations on an equivalent valuation, one should compare the earnings yields on stocks with the yieldson Treasury inflation-protected securities (TIPS) and bonds. TIPS haveabsolute certainty of purchasing power return and are the safest assets.Stocks are of course riskier, and they should bear a risk premium aboveTIPS.There is considerable debate on what constitutes a “normal” riskpremium between stocks and inflation-protected bonds, as is discussedin Chapter 2. Generally the equity risk premium is taken between 2 and3 percent, but it could certainly be higher in times of great uncertainty orlower when investors are very bullish on stocks.
Corporate Profits and National IncomeAnother indicator of stock market valuation is the ratio of corporateprofits to national income (GDP). Its rise in recent years has alarmedsome stock market analysts who worry that if the share of profits to national income falls to its long-term average, stock prices will suffer.Closer examination of this claim should put those fears to rest.Figure 7-5 displays the ratio of after-tax corporate profits and after-taxprofits plus proprietors’ income, and their sum since 1947. Proprietors’income is profits of nonincorporated businesses, including profits topartnerships and individual owners.One can see the long-term downtrend of proprietors’ income sharefrom the 1940s to the 1980s, which has recovered only slightly since then.Over this period many brokerage houses, investment banks, and otherfirms became publicly traded corporations, and some government-
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FIGURE
7–5
Market Value, Replacement Cost, and the GDP
sponsored firms such as Fannie Mae and Freddie Mac also became public corporations. The sum of corporate profits and proprietors’ income isonly slightly higher than its long-term average.Another consideration is that the fraction of corporate profits ofU.S.-based firms that come from abroad has also been increasing. In2006, over 44 percent of the sales of S&P 500 companies were foreign. Asthe U.S. economy shrinks relative to the size of the world economy, thecorporate profits of U.S. multinational corporations should rise relativeto the GDP.
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Book Value, Market Value, and Tobin’s QThe book value of a firm has often been used as a valuation yardstick. Thebook value is the value of a firm’s assets minus its liabilities, evaluated athistorical costs. The use of aggregate book value as a measure of the overall value of a firm is severely limited because book value uses historicalprices and thus ignores the effect of changing prices on the value of theassets or liabilities. If a firm purchased a plot of land for $1 million that isnow worth $10 million, examining the book value will not reveal this.Over time, the historical value of assets becomes less reliable as a measure of current market value.To help correct these distortions, James Tobin, a professor at YaleUniversity and a Nobel laureate, adjusted the book value for inflationand computed the “replacement cost” of the assets and liabilities on thebalance sheet.27 He developed a theory that the “equilibrium” or “correct” market price of a firm should equal its assets minus its liabilitiesadjusted for inflation. If the aggregate market value of a firm exceeds thecost of capital, it would be profitable to create more capital, sell shares tofinance it, and reap a profit. If the market value falls below the replacement cost, then it would be better for a firm to dismantle and sell its capital, or stop investment and cut production.Tobin designated the ratio of the market value to the replacementcost with the letter Q, and he indicated that its ratio should be unity ifthe stock market was properly valued. The historical values of “Tobin’sQ,” as the theory has become known, are shown in Figure 7-6. The ratiohas fluctuated between a high of 1.84 in 1999 to a low of 0.27 in 1920,with the average being 0.70.In 2000 Andrew Smithers and Stephen Wright of the United Kingdom published the book Valuing Wall Street,28 which maintained thatTobin’s Q was the best measure of value and that the U.S. markets aswell as the U.K. and many other European markets were extremelyovervalued by this criterion. There are some who maintain that Qshould generally be less than unity because older capital is not as productive as newly installed capital.29 If this is true, then the market waseven more overvalued in the late 1990s.27
James Tobin, “A General Equilibrium Approach to Monetary Theory,” Journal of Money, Credit, andBanking, vol. 1 (February 1969), pp. 15–29.28Andrew Smithers and Stephen Wright, Valuing Wall Street: Protecting Wealth in Turbulent Markets,New York: McGraw-Hill, 2000.29This is also because in equilibrium the marginal productivity of capital should be treated as beingequal to the cost of new capital, while the stock market measures the average productivity of bothold and new capital.
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FIGURE
7–6
Tobin’s Q = Ratio of Market Value to Replacement Cost of Capital
But there are critics of the Q theory. Capital equipment and structures lack a good secondary market, and hence there is no realistic wayto value much of the physical capital stock. The inability to value intellectual capital is a perhaps more significant drawback. Microsoft has abook value of about $40 billion but a market value over seven times aslarge. In fact, the value of most technology firms is composed of their intellectual capital.Smithers maintains that the existence of intellectual capital shouldnot be used to justify any gap between the book and market values. Although firms may own trademarks and patents, they do not own the entrepreneurs, engineers, or other employees that generate ideas. As longas there is a competitive labor market, accounting allowances for humanfactors of production must be calculated by their market values, just asphysical capital. The stock options lavished on employees during thetechnology boom of the late 1990s to keep key personnel from being bidaway by other firms are an example of this.This point is well taken, but some firms are more successful thanothers at creating and maintaining productive groups of talented individuals. Often employees can create more firm value by working together than they can by working separately, and other firms may not beable to create the same creative environment. The ability of the United
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States to draw talent from the rest of the world may create shareholdervalue in excess of the cost of hiring these workers.30It may be that in the very long run the market value of the tangibleand intangible capital must equal the cost of reproducing it. But bookvalue is a construct of the past; market value derives from prospectiveearnings and looks to the future. These prospective earnings more accurately establish the basis of stock valuation than the historical costs atwhich the firms purchased these assets.
Market Value Relative to the GDP and Other RatiosThe gross domestic product (GDP) is universally regarded as the bestmeasure of the overall output in the economy. It would be reasonable toassume that the market value (MV) of firms should bear some normalrelation to the size of the economy. Figure 7-7 shows the ratio of the market value of stocks to the GDP since 1900.30
Of course, one can reply that for every firm that creates a more productive environment, thereis another firm that creates an unsuccessful one and ends up overpaying and wasting intellectualresources.
FIGURE
7–7
Market Value of Equities as Percent of Total GDP
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The ratio of the market value of equity to the GDP can both theoretically and empirically exceed 1. Equity valuation is a balance sheetitem, while the GDP is an annual flow. Many firms have capital that farexceeds their annual sales, so it is not at all unusual for the value of aneconomy’s capital to be greater than its output.But more importantly, equity capital is only a part of total capital.Both debt and equity finance the capital stock, and the ratio betweenthem changes over time. In the 1990s as interest rates fell, many firms retired high-coupon bonds and reduced their leverage, a process calleddeleveraging. Deleveraging increases the value of equity and decreasesthe value of debt but leaves the total value of the firms unchanged. Asthe market has risen, more firms have become public companies. Thiswill increase the market value of stocks even if the total value of firms,public and private, remains unchanged.Moreover, the ratio of the market capitalization to the GDP differswidely among countries. Multinational firms might be headquartered ina particular country while their sales span the globe. As internationaltrade increases, it should not be surprising if the market value of firmsdeviates from the GDP of the country in which they are headquartered.Table 7-1 shows that the market value of shares traded in Hong Kong areover 600 percent of its GDP, while in Germany, Italy, and Japan the ratiois less than 100 percent. The variation between countries results fromlarge differences in the leverage, the fraction of firms that are publiclytraded, and the international scope of the firms headquartered there.One ratio that has very little meaning but is often seen in the pressis a time series of the ratio of a stock index such as the S&P 500 or theDow Jones Industrials to the GDP. Stock indexes report the averageprices of individual shares, not the total value of such shares that willTABLE
7–1
Summary Market Statistics for Various Countries as of February 2007: Market Value (MV) to GrossDomestic Product (GDP); P-E Ratio; and Dividend YieldStatistic
U.S.
Japan
Germany
Britain
MV/GDP*
136%
74%
53%
159%
602%
270%
47%
P-E†
19.0
24.1
15.9
18.9
14.9
17.6
14.8
Div. Yld.†
1.67%
0.97%
2.29%
3.54%
2.78%
1.62%
3.53%
*Data for market value (MV)/GDP are for February 17, 2007.†P-E and dividend yield are based on last 12 months of earnings and dividends.
Hong Kong Switzerland
Italy
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increase over time as new firms go public. Another misleading time series is a representative stock index against average housing prices. Theflow of housing services, or rental income, is not included in the price ofhomes, while stock price indexes include capital gains caused by reinvested earnings.
CONCLUSIONThe fundamental determinant of stock values remains the earnings of acorporation, from which dividends are paid, and the interest rate thatdiscounts those dividends. The best concept of earnings is the “coreearnings” concept developed by Standard & Poor’s in 2002, which wasthe first to fully expense options and make adjustments to pension income. The earnings yield, which is the reciprocal of the P-E ratio, is agood predictor of future real stock returns.One of the most difficult issues in economics is to know when therehas been a basic structural shift in the economy and when there has not.Admittedly, there are too many times, such as the technology bubble atthe end of the last century, when speculators used “new era” economics tojustify unreasonably high prices. But there are also times when there hasbeen an important structural shift, such as in the 1950s when the dividendyields on stocks fell below the interest rates on long-term Treasury bonds.There have been some important shifts in recent years. The fall inthe dividend payout ratio has shifted stock returns from dividends tocapital gains, impacting the growth rates of future earnings and dividends. Furthermore, the dramatic fall in transactions costs combinedwith the increase in macroeconomic stability may also change the P-Eratio of stock prices to valuation metrics. How these events will impactfuture stock returns will be discussed in the next chapter.
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8
CHAPTER
THE IMPACT OF ECONOMICGROWTH ON MARKET VALUATIONAND THE COMING AGE WAVEThe term “new economy” has become, beginning in 2000, a fad in itself. It appears suddenly as a new name for our hopes and for economic progress due to recent technological advances, notably theInternet, and for our reasons to think that the future growth prospectsare ever so brilliant.ROBERT SHILLER, 20011
What are the most important macrotrends in the economy that influencefuture stock market returns? Economic growth immediately comes tomind. But economic growth has nowhere near as big an impact on stockreturns as most investors believe. However, other important trends dohave a positive impact on stock valuation: the stability of the overalleconomy, the reduction in transactions costs, and the change in taxes onstock market income.1Robert Shiller, Irrational Exuberance, New York: First Broadway Books, 2001, Afterword to the paperback edition, p. 249.
123Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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Yet all of these factors may be eclipsed by the most importantmacroeconomic trend of the next two decades—the hundreds of millions of baby boomers from the developed world that are planning to finance their retirement by selling their financial assets. This chapter willanalyze all these issues, coming to the conclusion that the long-term future of equity returns looks bright if the United States keeps its capitalmarkets open to the rest of the world.
GDP GROWTH AND STOCK RETURNSSome very surprising results are shown in Figure 8-1. In Chapter 1 wereported on the long-term stock returns of 16 major markets around theworld from 1900 through 2006. The long-term dollar returns of eachcountry reported against the average real growth of its GDP are plottedin Figure 8-1a. The results are striking. Real GDP growth is negativelycorrelated with stock market returns.2 That is, higher economic growthin individual countries is associated with lower returns to equity investors.3 Similarly, the stock returns for the developing countries againsttheir GDP growth are plotted in Figure 8-1b.4 Again, despite the huge returns chalked up to developing markets in recent years, there is a negative relation between the returns to individual countries and the growthrates of their GDP.Why does this occur? Since stock prices are the present value of future dividends, it would seem natural to assume that economic growthwould positively impact future dividends and hence increase stockprices. But the determinants of stock prices are earnings and dividendson a per share basis. Although economic growth influences aggregateearnings and dividends favorably, economic growth does not necessarily increase the growth of per share earnings or dividends. This is becauseeconomic growth requires increased capital expenditures, and this capital does not come freely.Implementing and upgrading technology requires substantial investment. These expenditures must be funded either by borrowing inthe debt market (through the banks, trade credit, or by selling bonds) or2
This is an update of the chart that was presented in the second edition of Stocks for the Long Run(1998) as Figure 9-2 but omitted from the third edition.3Elroy Dimson, Paul Marsh, and Michael Staunton confirm my findings in the Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, N.J.: Princeton University Press, 2002), butthey do not provide an explanation for it.4This is an updated version of Chart 16 in Jeremy Siegel, The Future for Investors: Why the Tried andthe True Triumph over the Bold and the New, New York: Crown Business, 2005.
CHAPTER 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave
FIGURE
125
8–1a
Long-Term Dollar Returns Reported for 16 Countries against Each Country’s Average Real GDPGrowth, 1900 through December 2006
by floating new shares. The added interest costs (in the case of debt financing) and the dilution of earnings (in the case of equity financing) reduce the growth of per share earnings.It is possible that growth can occur in the short term without capital expansion by using the existing plant more intensely. But the longrun historical evidence strongly suggests that capital must be expandedto support higher growth. One of the signal characteristics of long-termhistorical data is that the level of the capital stock—the total value of allphysical capital such as factories and equipment as well as intellectualcapital—has grown over time roughly in proportion to the level of aggregate output. In other words, a 10 percent increase in GDP ultimatelyrequires a 10 percent increase in the capital stock.55
For a good summary of all this literature, see Jay R. Ritter, “Equity Growth and Equity Returns,”Pacific-Basin Finance Journal, vol. 13 (2005), pp. 489–503.
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FIGURE
8–1b
Long-Term Stock Returns for 25 Developing Countries against Each Country’s Average Real GDPGrowth, Various Starting Years through December 2006
The Gordon Dividend Growth ModelThe belief that growth automatically boosts stock prices grows out ofthe misuse of a popular model for valuing stocks—namely, the Gordondividend growth model developed by Roger Gordon in 1962.6 In Chapter7 we noted that the price of a stock is the present value of all the futuredividends. It can be easily shown that if dividends grow in the future ata constant rate g, then the price per share of a stock P can be written asfollows:P⫽
6
dr–g
Myron J. Gordon, The Investment, Financing, and Valuation of the Corporation, Homewood, Ill.: Irwin,1962.
CHAPTER 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave
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where d is next period’s dividend per share, g is the constant rate of future growth of dividends per share, and r is the discount rate that investors apply to stock.From this model, it appears as if an increase in growth g unambiguously raises the price of shares. But the g in the Gordon equationrefers to the growth in per share dividends, not the growth in aggregatedividends, and the two concepts can deviate substantially, as the historical data confirm.
ECONOMIC GROWTH AND STOCK RETURNSThe summary statistics for dividends per share, earnings per share, andstock returns for the U.S. economy from 1871 through December 2006are shown in Table 8-1. The data show that real per share earningsgrowth over the entire 135 years has averaged a paltry 1.88 percent,considerably below the growth rate of real GDP, which is about twicethat number. As noted above, because shares and/or debt must be usedto finance capital expenditures, earnings per share growth do not matchaggregate economic growth over the long run.It is also of interest that the growth of earnings and dividends pershare is higher since World War II than before even though the GDPgrowth is lower. The cause of the higher earnings growth in the last 60years is the decline in the dividend-payout ratio and subsequent increase in the use of retained earnings to finance growth.As explained in Chapter 7, the valuation of a firm is independent ofthe dividend policy chosen as long as the rate of return on retained earnings is identical to that demanded by shareholders. This can be shownTABLE
8–1
Summary Statistics for Dividends per Share, Earnings per Share, and Stock Returns for the U.S.Economy, 1871 through December 2006Real GDPGrowth
Real per ShareReal per ShareEarnings Growth Dividend Growth
Dividend Yield*
Payout Ratio*
1871-2006
3.57%
1.88%
1.32%
4.58%
58.17%
1871-1945
3.97%
0.66%
0.74%
5.29%
66.78%
1946-2006
3.09%
3.40%
2.03%
3.53%
51.38%
*Denotes median.
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by the Gordon model. If a firm cuts its dividend d and uses the proceedsto earn a rate of return r, the growth of future dividends g will rise byjust enough to keep price of the stock P, unchanged under the lower dividend.The low growth of real historical earnings per share has causedsome economists to predict low future real returns for the stock market.In 2002, at the bear market low, Robert Arnott and Peter Bernstein predicted that the current low dividend yield when added to the historicalgrowth of real earnings will yield future real stock returns of between 2and 4 percent.7But these pessimistic predictions proved wrong because they ignored the impact of the lower dividend-payout ratio on earningsgrowth.8 As noted above, a reduction in the dividend increases retainedearnings, and if the return that management earns of its retained earnings is identical to the return demanded by shareholders on its stock,then the increase in earnings per share growth will exactly offset the decrease in the dividend yield.9 One must not forecast future real returnsfrom historical earnings growth rates when the payout ratio haschanged.
FACTORS THAT RAISE VALUATION RATIOSWe have noted that the historical real return on equity has been between61⁄2 and 7 percent per year over long periods and that this has coincidedwith an average P-E ratio of approximately 15. But there have beenstructural changes in the economy in recent years that may change thatratio.Two of these changes relate directly to the expected rate of thereturn on equities and one to the equity risk premium.
7Robert D. Arnott and Peter L. Bernstein, “What Risk Premium Is ‘Normal’?” Financial AnalystsJournal, vol. 58 (2002), pp. 64–85. As noted in Chapter 