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What investment return should an investor expect from a diversified portfolio of common stocks As a proxy for the market, let s use the rate of return associated with the S&P 500 Index and compare its performance with the change in operating earnings per share associated with the stocks that comprise the S&P 500 Index. During the 70-year period from 1928 to 1997, the S&P 500 had a compound average return of 10.6 percent. In more recent years, stock return performance has gone from spectacular to abysmal. Look at Table 3-3. In calendar years 1997, 1998, and 1999, the total returns on the S&P 500 Index were 31 percent, 26.7 percent, and 19.5 percent respectively. But unless the companies are propelled by a similar percentage increase in profits or a general decrease in interest rates, general stock market performance that good can t last forever. It didn t the market turned, the bubble burst, and the stock market has experienced three years of negative numbers. The S&P 500 was down (10.1 percent) in 2000, (13 percent) in 2001, and (23.4 percent) in 2002. During the 1996 2002 period, overall stock market performance has been poor to anemic. Remember our discussion in Principle 5 about using compound average returns rather than simple averages The differences between the two are shown at the bottom of
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STREETSMART GUIDE TO VALUING A STOCK
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TABLE 3-3
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1997 2002 S&P 500 and S&P Operating Earnings
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S&P 500 Index 879.82 1,148.08 1,320.28 1,469.25 1,229.23 970.43 740.74 % Change 23.37% 13.04% 10.14% 19.53% 26.67% 31.01% 5.11% 2.91% S&P Earnings 46.04 38.85 56.13 51.68 44.27 43.73 40.63 % Change 18.51% 30.79% 8.61% 16.74% 1.23% 7.63% 3.66% 2.11%
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Year 2002 2001 2000 1999 1998 1997 1996
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6-year simple avg. 6-year compound avg.
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Table 3-3, and shows that simple averages overstate the performance of the S&P 500 Index. So we focus on compound averages. The compound average return on the S&P 500 for the six-year period was 2.91 percent not too far from the 2.11 percent compound average growth rate of the operating earnings of the companies that make up the S&P 500 Index. What are reasonable returns to be earned in the stock market over a long time period Jeremy Siegel, in Stocks for the Long Run,1 found that 7.13 percent was the average real yearly return, dividends plus appreciation after adjusting for inflation, from owning stock over the 50year period from 1946 to 1996. This return is very close to the 6.96-percent median earnings yield, which he defines as corporate earnings per share divided by stock price, for the same time period. Historically, as a company s earnings have increased, its stock price also has increased proportionately to maintain this earnings yield. Siegel finds that real returns (after inflation) for common stock closely track real growth in corporate earnings, and stock prices in the long run are a very strong function of real growth in corporate earnings. For a first cut at expectations for stock returns from a diversified portfolio of stocks, investors should expect a real return that is roughly in line with the growth of corporate earnings.
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Stock Valuation: Some Preliminaries
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The famous economist John Maynard Keynes scoffed at long time horizons, noting that in the long run, we are all dead. Then what about the short run Stock prices exhibit an immediate and very strong inverse relationship to movements in interest rates. In general, as interest rates (and a corporation s financing costs) go down stock prices go up, and as interest rates go up stock prices go down. Siegel believes and we agree that interest rates, in the short and intermediate time frame, are the single most important influence on stock prices. He analyzed Federal Reserve monetary policy over a 42year period from 1955 to 1996. His results were quite striking. Siegel found that the three-month average return for the stock market, after significant decreases in the Fed Funds rate (85 instances), was 5.6 percent. When the Fed increased the Fed Funds rate (92 instances), the three-month average return for the stock market was only 0.85 percent. The benchmark three-month average return during this period was 2.97 percent. The three-month return of 5.6 percent, after Fed Fund rate decreases, versus the three-month return of 0.85 percent, after Fed Fund rate increases, is a significant difference in stock market performance. Fed Funds rate movements have been a good predictor of short-term stock returns.2 During the 1997 2002 time period shown in Table 3-3, long-term interest rates, as measured by the 10-year U.S. Treasury yield, declined from 6.41 percent at the beginning of 1997, to 3.82 percent at the end of December, 2002. This decline in interest rates has greatly increased intrinsic stock values, and we explain why in 6. The DCF approach uses both cash flow and interest rate measures as the two primary influences on intrinsic stock value. The direct relationship of a stock s value to corporate cash flow is examined in 5. The inverse relationship of a stock s value to a change in a corporation s weighted average cost of capital (WACC), especially through changes in interest rates, is described in 6.
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