Corporate Profits Versus GDP
Many investors speak about how profit margins are unsustainably high and/or corporate profits as a percentage of GDP are exceptionally high. These points appear quite reasonable because in the long run corporate profits cannot grow faster than GDP or else they would overtake the economy which is unfeasible.
A more realistic assumption is that corporate profits grow in lock-step to nominal GDP. However, there are some issues around what constitutes GDP.
Nearly half of the S&P 500 sales are from overseas as of 2015, and global GDP growth has been on average a bit faster than US GDP growth, so in theory S&P profits can outgrow the US GDP for a long time as long as the world grows faster.
As an example, imagine a country X with 0% nominal GDP growth while the rest of the world grows at 5% annually. If that country X has corporations the sell a substantial amount of product to the entire world, it us not unreasonable to expect that the profits for corporations in country X aren't constrained to grow at 0%, but instead may exhibit positive growth over the long term as the rest of the world grows, and the country's corporations have investments throughout the world.
To be conservative we will just use US GDP. Since the great recession ended, that is from 2010 through 2016, the nominal GDP has grown on average 3.7% annually from 2009 through 2016.
It is realistic to expect this to continue since US economic projections are for 2% real growth from the Federal Reserve. These figures do account for cyclicality and periodic recessions. The average inflation rate per GDP deflator since 2009 has been 1.6% and the US Federal Reserve target is 2%, so we can safely assume an average inflation of 1.6%. Putting the two together, a 1.6% inflation rate combined with 2.0% real GDP growth leads to an expectation of 3.6% long term nominal GDP growth. For simplicity let's just assume 3.5% nominal GDP growth.
Other Components of Total Return
Right now the S&P 500 trades at 2459 as of the close on 7/14/2017, and it is expected to earn $128 in operating EPS for 2017 and $146 in 2018 for a forward 12 month average of about $137. Based off the $49 in current run rate dividends, the yield is 2.0%. The current recent buyback run rate as a percent of market cap has been closer to 3.0% for the last decade, which would imply about $74 in buybacks. However, there is always dilutive share issuance, so it appears as though the net reduction in share count has been in the 2.5% range for the last 10 years, which implies a reasonable 0.50% dilution rate from share issuance primarily from compensation. Then a 2.5% figure for assumed share count reduction may be more appropriate. Essentially, this assumes buybacks are 3.0% of market cap, but due to 0.50% annual dilution, share count is only reduced 2.5%. With $49 in dividends and $74 in buybacks, this allows $14 per share in retained earnings to be reinvested.
As a check for reasonableness, this scenario of 3.5% nominal profit growth would assume $4.8 of new S&P profits are generated based on $14 of retained earnings which implies roughly a 34% marginal ROE. The recent S&P 500 ROE has been in the 15% range, which is for overall ROE, not marginal. Therefore, a 34% implied marginal ROE, appears high.
So to review, the assumption here is for 2.0% dividend yield. Then there's a 2.5% annual reduction in share count plus a 3.5% nominal profit growth leading to 6.0% annual EPS growth. The 6.0% annual EPS growth and 2.0% dividend yield leads to an approximated long term expected return of 8.0% for the S&P, under these assumptions. However, the required 3.5% nominal annual profit growth implied a 34% ROE, which appears high, and on the surface may invalidate this analysis.
A missing piece may be leverage. If we assume the S&P 500 companies on average have debt equal to 25% of their market Cap, then there is $615 in debt for the S&P. However, if nominal profit were to grow 3.5% annually in long term, with no additional increase in debt, this would not be leverage-neutral, and eventually, leverage would near zero. A fair assumption is that the total nominal debt would also increase 3.5% annually to maintain constant leverage, which means $22 in new debt annually. Long term seasoned Baa bonds have an effective yield of 4.4% as of July, 2017. Assuming an S&P 500 effective tax rate of 25% for simplicity, the net interest cost is 3.3% on this debt. However, calculating the return on this debt is tricky-if we assume it is for buybacks, then an 8.0% return is appropriate since that was our expected long term equity return, but the ROE for the S&P 500 is overall in the 15% range, so that would perhaps be an upper bound. To be conservative, we'll assume a safe 8.0% return on new debt. So if $22 of new debt is issued at a net after tax interest cost of 3.3%, which generates an 8.0% return, for a net return of 4.7%, then it creates about a $1 per share accretion. The $1 per share of accretion from additional debt allows a scenario where out of the total required $4.8 in assumed nominal profit growth, only $3.8 would need to be generated from retained earnings. So $3.8 profit from $14 in retained earnings leads to a marginal ROE of 27%, which is less outlandish.
Review of Assumptions
The estimated long term S&P return generated was 8.0% comprised of 6.0% EPS/dividend growth (3.5% growth nominally, and 2.5% share count reduction) combined with a 2.0% dividend yield.
Assumptions may be conservative:
- On the GDP front, global GDP continues to grow faster than US GDP, and the assumptions were made based on only US GDP growth even though about half of S&P 500 sales are overseas.
- Also, with so much of the assumed total return occurring from capital returns in the form of buybacks and dividends, any drop in the S&P valuation would benefit expected long term returns, since the dividend yield and buyback yields would increase. Many metrics like forward PE suggest the S&P 500 is a little bit elevated from a valuation perspective.
- The assumed inflation component of long term nominal GDP growth was 1.6%, which is below the historical inflation rate, and the Fed's 2.0% target.
Assumptions may be generous:
- The assumed profit growth may be a bit too high since it implies a 27% marginal ROE which is elevated compared to overall ROE in the 15% range.
- The GDP growth assumption was based on Federal Reserve Targets for real GDP growth, which often has been overly optimistic.
Many who try to forecast total return link S&P long term (30 years) total returns to nominal GDP growth plus dividend yield. Although this appears to have been a good proxy in pre 1970 period, it recently has underestimated actual returns because buybacks are not being factored in, and they function like a dividend. However, they allow earnings to grow faster than nominal GDP indefinitely, in the long run, so the net buyback as % of market cap must be either added to nominal GDP to goose the expected EPS growth, or added to the dividend yield. In this analysis, I added buyback impact to nominal profit growth, to goose EPS growth.
The dividend yield plus nominal GDP growth method of estimating total returns would be understating true total returns due to buybacks, in the years after 1982, when buybacks became prominent. It appears as though, even after adjusting for buybacks, it still understated total long term returns due to substantial PE expansion, and the fact that global GDP has grown faster than US GDP since the 1960s, thus allowing S&P companies nominal profits to grow faster than US GDP as they become more levered to the faster-growing global GDP.
Based on these set of assumptions, one can expected long term S&P 500 returns to be in the 8.0% range. Of course, as one invests over a shorter period of time, the actual total returns would deviate from 8.0% because fluctuations in the valuation multiple of the S&P 500, although becoming mostly drowned out over the very long term, have a huge impact in the short run. If the S&P 500 PE multiple were to expand 10% higher over 1 year, it would pad total return by 10%, all else equal. However, if the same expansion were to occur over the very long term, say 40 years, it would hardly pad returns, since it would constitute 0.25% annual multiple expansion, but higher valuations would likely suppress intermediate dividend yields, thus serving as an offset to multiple-expansion and actually reducing return.
There were numerous assumptions and calculations here, so feedback and/or criticism is very welcome as it makes for better discourse on such an important topic- what investors can expect in terms of long term total return from the US Equity Market's biggest benchmark, the S&P 500, in exchange for taking on equity market risk.
Additional Disclosure: The information contained in this article is an opinion and constitutes neither actionable investment advice nor a recommendation to trade any security.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.