Wednesday, February 10, 2010

Earnings & Dividends Determine Long-Term Stock Market Returns

In the long term, the contribution of earnings growth and dividends to total return dominates the contribution made by changes in p/e ratio.  We saw in an earlier post that changes in the price/earnings (p/e) ratio had a disproportionate impact on yearly stock market returns. In this post, we will see that over time earnings growth and dividends win out.

The Contribution of Earnings Growth and Dividends to 50-Year Stock Market (Dow) Total Returns

Contribution to 50-Year Stock Market Returns

The stacked bar chart above (click to expand) shows the market's annualized total return for 50-year periods beginning in 1920; the segments of the bar show
the relative contributions to total return made by earnings growth, dividends, and changes in valuation (normalized price/earnings ratio). For example, the first bar shows that an investor buying the DJIA (Dow Jones Industrial Average) Index in 1920 and holding for 50 years would have earned a total of 10% per year -- assuming he reinvested the dividends each year. Investors earned 4% per year from the growth in normalized earnings, 5% from dividend income, and 1% from the increase in the NPE ratio. (Note: For more detail on the methodology I use to decompose returns, see Analyzing and Understanding Stock Market Returns. )

What can we learn from this graph?

Long-Term Earnings Growth Has Been About 6% per Year

Because we're looking at 50-year periods, there are only 34 data points in our sample, so we'll have to take some of the results with a grain of salt. Still, the "recent" consistency of the contribution from earning is remarkable. For periods beginning in 1935 or later, the earnings growth contribution, represented by the red segments, is right at 6%/year.  However, it's worth noting that for earlier periods the growth rate was somewhat less.  These results are consistent with the 5.72%/year growth rate that I derived by a different method in Stock Market Earnings Growth History.

The Importance of Dividend Contributions to Total Return

For much of this century dividends (the blue segments) have contributed about 4% per year. In other words, dividends have historically contributed at least two-thirds as much as earnings growth.  In the early 50-year periods, dividends often contributed as much as earnings, and sometimes more.

Total Core Returns Have Averaged Around 10% per Year

By "core," I mean returns coming from dividends plus earnings growth. The core returns appear to be averaging about 10% per year. Changes in the normalized p/e ratio sometimes add a little, and sometimes subtract a little. This squares with the observations elsewhere that long-term returns have been on the order of 9-10% per year. Note that this means that over the long-term, dividends have accounted for about 40% of total return.

In the Long Term the Impact of Changes in Normalized P/E (NPE) Ratio is "Small"

Compare the graph in this post to the graph of contributions to yearly return; the difference between the two graphs is remarkable! In the earlier graph the change in NPE is the key determinant of return. That is, looked at from year to year, the impact of changes in normalized p/e ratio (NPE) is much greater than the impact of either earnings growth or dividends.  However, over a 50-year time span, the impact of NPE dissipates. 

Valuations (P/E Ratios) in the Start Year Matter

Though the impact of NPE in the 50-year chart is much, much smaller than in the one-year chart, it still cannot be ignored. For example, buying at the high NPE ratios before the 1929 crash cost investors over 2.5% per year -- for the next 50 years! As I explained in stock market returns in dollars, small percentage differences add up to big dollars when compounded over many years.  In this case, if the original investment was $10,000, the difference between earning 10%/year and earning only 7.5%/year for 50 years is ($1,174,000 - $372,000 =) $802,000!

Note: These results are based upon my Stock Market Analysis Model. Earnings and dividends prior to 1929 have been estimated based on another stock market index.

Related Posts

Other Posts in this Series
Components of 10-Year Stock Market Returns: Same as this post, but for 10-year periods. Very different results.
The Extraordinary Impact of P/E Ratios: shows the contribution of earnings, dividends and p/e for one-year periods. Equally different.

Other Related Posts
Dow Dividend Yield History shows a disturbing trend in valuation when looked at from the dividend yield and price/dividend ratio point of view.
50-year rolling returns: a slightly different, higher level view of 50-year returns.
How the Stock Market Projection Model Works uses the results of this post as the foundation for projecting future returns.
For lists of other popular posts and an index of all stock market posts, by subject area, see the sidebar to the left.

Copyright © 2010. Last modified: 2/20/2012

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  1. Could you please inform the source of the Dow Dividend and EPS data. And is that something that you can share with a researcher? Thanks.

    1. James,
      Please see the article re methodology linked to in the second paragraph.

      p.s. sorry I didn't see your comment earlier.


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