A Tautology For Future Returns: A Formula That Is Always Right

by: Ronald Surz

Summary

Investment returns accrue from 3 sources: dividend yield, earnings growth and P/E expansion or contraction.

Estimates of these 3 variables going forward can be used to forecast investment returns.

I provide a table that converts your estimates into return forecasts over the next 12 months.

The following formula is always correct because it is a tautology. To predict the future, simply estimate earnings growth and P/E expansion or contraction, which is driven by investor behavior.

Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) - 1

The following table shows where we are now and highlights ranges of possible 12-month futures.

Click to enlarge

Most observers see earnings growing less than 6%. If P/Es remain at their current level, returns will be somewhere between 5 and 9% - single digit. If P/Es contract to their average level of 15, returns will be somewhere in the -18 to -21% range - double-digit losses.

What is your outlook for earnings growth in the stock market over the next 12 months? Where do you see P/Es a year from now? You can look up your cell (forecast) in the table above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.