Estimating The Equity Risk Premium: A New Look
“In the short run, the stock market is mostly driven by demand….. causing over- and under-reactions to underlying fundamentals. But in the long-run, the cash-flows that corporations supply are the ultimate drivers of stock returns.”
PHILLIP STRAEHL AND ROGER IBBOTSONFINANCIAL ANALYSTS JOURNAL, 2017
The ‘Total Payout Model’ of Stock Returns
The new FAJ article “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy” cited above shows that in a world where share buybacks are a material factor in how corporations return capital to shareholders, the simple return model of R=DivYield+DivGrowth will underestimate future stock returns. Why? Because share buybacks increase growth in total payout per share. So while dividends are captured as cash payments, buybacks (BB) need to be captured as payments that grow price per share: R=DivYield+BBGowth+DivGrowth.
In this return framing context, Straehl and Ibbotson (SI) estimate the 1871-2014 real return on US stocks as R=4.5%+0.8%+1.5%=6.8%. Looking ahead, they project an expected real return based on a current dividend yield of 1.9%, BBGrowth based on average share buyback experience over the course of the last 10 years of 1.7%, and continuation of the long-term historical divided growth experience of 1.5%: R=1.9%+1.7%+1.5%=5.1%. A key message in the SI article is that, based on the assumed continuation of average share buyback experience of the last 10 years, the BBGrowth factor is almost as important as the current dividend yield in calculating the expected long-term return of a broadly-based equity portfolio today. In their article, IS call the sum of the DivYield and BBGrowth (i.e., 1.9%+1.7%=3.6%) the ‘Payout Yield’.
A look at the earnings yield of the S&P500 today confirms that the 5.1% real return estimate by way of the ‘total payout model’ is realistic. Projected 2017 earnings for the index currently average $130 versus a current index value of 2433. That leads to an earnings yield of 5.3%, close to the IS expected return calculation of 5.1%, made up of a Payout Yield of 3.6% and a DivGrowth projection of 1.5%.
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