Blog - Investing Notes

November 11, 2005 – Classic Research: Stock Returns in the Long Run

We have selected for retrospective review a few all-time "best selling" research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the March 2002 paper entitled "Stock Market Returns in the Long Run: Participating in the Real Economy" (download count over 3,400) by Roger Ibbotson and Peng Chen. The authors examine the relationships during 1926-2000 between historical equity returns and key supply side factors such as inflation, earnings, dividends, price-to-earnings ratio (P/E), dividend payout ratio, book value, return on equity and GDP per capita. They extrapolate these supply side connections with the real economy to estimate the future long-term equity risk premium. They conclude that:

• Growth in corporate earnings is in line with the growth of overall economic productivity.
• P/E expansion accounts for only 1.25% of the total geometric mean annual return from stocks of 10.70%. This P/E expansion more than accounts for the the growth in equity capitalization relative to the overall economy.
• The bulk of the return from stocks comes from dividends and nominal earnings growth (inflation plus real earnings growth).
• A secular decline in dividend yield and payout ratio makes dividend growth alone a poor measure of corporate profitability and future growth.
• The estimated future long-term equity risk premium (relative to the long-term government bond yield) based on supply side analysis is about 6% arithmetically and 4% geometrically, in line with historical results.

The paper reviews six methods of decomposing historical equity returns: (1) Building Blocks Method; (2) Capital Gain and Income Method; (3) Earnings Model; (4) Dividends Model; (3) Return on Book Equity Model; and, (6) GDP per Capita Model. The following chart, extracted from the paper, compares the results of methods (1) and (2) for the period 1926-2000. In this chart, ERP is equity risk premium, RRF is the real risk free rate, CPI is the Consumer Price Index (inflation), INC is dividend income, RCG is real capital gain, g(P/E) is growth rate of P/E, and g(EPS) is growth rate of earnings per share. The blue block on the top is the re-investment return plus the interactions among the components.

The paper also provides other interesting charts for the period 1926-2000 and an overview of different general approaches to estimating the equity risk premium.

In summary, a supply side analysis indicates that stocks will outperform long-term government bonds by an arithmetic average of 6% annually.

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.