Tuesday, January 02, 2007

Why S&P 500 Returned 10 Percent?

I recently read the “The Little Book of Value Investing” by Christopher H. Browne over the holidays and thoroughly enjoyed it. One passage of the book in particular caught my eye for its simplest explanation of the 10% historical return of the S&P 500 index, and I thought I should share it with you. You can find the following quote on the page 20 of this book.

"If you think the Standard & Poor’s 500 stock index as a giant conglomerate with 500 divisions, you will observe that over long periods, its earnings have grown on average about 6 percent per year. Typically, 3 percent of the increase has come from the growth of Gross National Product, and 3 percent has come from inflation. Therefore, the intrinsic value of the S&P 500 thought of a single company increases about 6 percent a year. In addition, the S&P 500 pays a dividend. Historically, the dividend yield of the S&P 500 has been in the range of 3 percent to 4 percent. Take the sum of the long term earnings growth (6 percent) and the dividend yield (4 percent), and you get a long-term annually compounded rate of return for the S&P 500 of about 10 percent. This is the return investors in an index fund expect to make over the long term. And if they stay in the index fund long enough, they should get that return."

Happy reading.


Anonymous said...

Doesn't the dividend yield derive from earnings, and thus, isn't adding the 6% earnings growth to the 4% dividend yield constitute double counting? What am I missing?

Anonymous said...

IF GDP is 3% and Inflation in the future is the 2% "target" of the FED, and the dividend yield is currently approximately 1.8% this thinking would mean long term returns of 6.8% and not 10%. With the dividend dropping from 4% to 1.8% currently it would appear GDP or inlation must make up 2.2% combined to get to 10%. How one moves either from the long term average of 3% (and remeber the 2% "target" on inlation) should present macroeconomists with a topic to write and debate about in journals galore. Going forward 10% looks doubtful.

Jonathan said...

This is the same as what Bogle says in the Little Book of Common Sense Investing. Any variations are contractions and expansions of P/E ratios.

Datasource2000 said...

It's not double counting. The DIVIDEND does derive from earnings, but the earnings GROWTH comes from "retained earnings", the amount the company keeps to reinvest back in the business.

Going back to 1930, the trend has been incredible steady, IF you look at 5, 10 year time frames and such.

6.4% earnings growth, and 3.6% dividend.

IMHO, the "target" for inflation is irrelevent, again, in the long run. Stocks price themselves to return 10%(ish), through the Depression, Wars, Booms and Busts: they revert back to that 10% mean.