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A case for solid growth - Eureka Report article

A case for solid growth

Scott Francis    30 January 2013
Summary: While there is a view that the sharemarket will settle back after its current short-term surge, there is also a strong case that the market will continue to rise and deliver solid earnings growth for shareholders through earnings per share and dividends.

Key take-out: On the basis of long-run earnings growth figures, equities should deliver solid returns over the medium term.

In his article last week 
Prepare for modest medium-term growth, Doug Turek put the case that the current equity market surge is a short-term phenomenon, and that we are actually heading into a period of lower returns from equities as company earnings come under pressure.

Indeed, Doug noted that “as the mining boom recedes and fears of a recession potentially emerge later in the year, it will be difficult for local companies to grow profits from belt-tightening consumers and corporates”.

“History suggests (We’ve been here before) debt hangovers can easily last a decade, which means we shouldn’t expect too much from the US, Europe and Japan and their factory – China.”

As such, Doug said that future investment returns from growth assets could be much more modest than they have been in the past.

This is an interesting forecast – and one that seems intuitively reasonable given the lower period of returns that we have experienced from investing in shares over the past 5½ years. But based on the current average company price to earnings (P/E) ratio across the Australian sharemarket, I am tipping healthy medium-term market returns for investors.

While my position is that forecasting the future in terms of sharemarket returns is an activity fraught with danger, I think that the key to predicting returns is to consider where sharemarket returns actually come from. The long-run return from shares has been about 7% a year after inflation, and I think there is a good possibility of seeing that return into the future.

William Bernstein (click here) wrote a great essay on where returns come from, arguing that future returns were a function of:

  • The income paid to owners of shares (I am going to use the earnings of the shares owned);
  • The growth rate of earnings; and
  • The market multiple (P/E ratio) paid for shares.

Before going any further, he also emphasises that: “Nobody knows what the market is going to do tomorrow, next month, or even in the next five years”. With that important disclaimer made clear, it is interesting to see where returns actually come from, particularly as the analysis treats owning shares like owning a portfolio of companies, which is exactly what it is.

The first source of returns – earnings

The first source of returns is that in owning shares (businesses), you receive the benefit of the earnings from the businesses you own. The managers of the business will choose how to use these earnings – they could be used for activities as diverse as paying shareholders a dividend, investing in new projects (e.g. opening new stores for a retail business), reducing the amount of debt a business might have or buying back shares, to reduce the number of shares a business has. All of these activities should provide a benefit to shareholders.

A simple way of measuring business earnings is the P/E ratio, but at any one time different organisations will have different expectations of the average market P/E ratio. The source I use, derived from index funds that report P/E for their portfolios, suggests that the current average P/E ratio of the market is 14.

An average market P/E ratio of 14 means that for every $1 of business earnings, investors are willing to pay $14.

To put this another way, it means that for every $100,000 invested, the businesses will produce $7,142 of earnings. This simple analysis reminds us of the fundamental aspects of share ownership that can be forgotten in a world of technical analysis, short-term commentary and economic discussion – which is that when you own shares you are a part owner of a business/businesses, and you benefit from the earnings that they generate. I have used a market average P/E ratio to calculate earnings – if you own a portfolio of specific companies, you could consider the P/E ratio of each company to calculate earnings.

The second source of returns – earnings growth

A key benefit of the $7,142 of earnings from owning businesses is that we expect those earnings to increase over time.

Last week I looked at the 110-year growth rate of dividends as being 1.1% a year greater than inflation. This is a reasonable approximation for not only the growth in dividends, but also the growth in earnings. Assuming that companies pay out a reasonably constant amount of their earnings as dividends (usually around 60% to 70%), then the growth in earnings and the growth in dividends will be almost the same.

However, I am going to be conservative and use a growth rate basically equal to inflation (3% a year). Even though long-run earnings/dividends growth in Australia has been higher than this, the Australian sharemarket has still had comparatively attractive long-run earnings growth. Rather than assume that this will continue in the future, it is more realistic to assume a more conservative earnings growth rate in line with inflation.

This assumption is able to be justified on an intuitive basis. Let’s think of our portfolio of businesses that cost us $100,000 to buy, and generated $7,142 of earnings. Digging further into these figures, let’s assume that the businesses we own sold $30,000 of goods and services. It cost them $22,858 (which includes tax paid) to produce these goods and services, leaving earnings of $7,142. If we assume that they increased their sales in line with inflation, and inflation is 3%, next year they will sell $30,900 of goods and services. Their costs also increase in line with inflation, so in the next year they will have costs of $23,544. This leaves earnings of $7,356 – an increase of 3%. So, if sales increase in line with inflation (through increased prices), and costs increase in line with inflation, then so will earnings.

The third source of returns – what people are prepared to pay for your company earnings

The P/E ratio of the market effectively tells you how much people are prepared to pay for the earnings that your companies generate. When the P/E ratio is high (say 15 times or higher), then people are prepared to pay you a lot for the earnings that your company generates. When the P/E ratio is low (say 10 times or less – for example during the global financial crisis), then they are not prepared to pay you all that much for the earnings your company generates.

Let’s consider our companies with combined earnings of $7,142. Given a P/E ratio of 14, that means that people are prepared to pay $100,000 for $7,142 of earnings. If investors suddenly became buoyant about the future, they might be prepared to buy shares on a P/E ratio of 18 – effectively paying $128,556 for those companies. Conversely, if investors become pessimistic about the future and are only prepared to buy shares on a P/E ratio of 10, then they would only pay $71,420 for those companies.

The change in what people are prepared to pay for company earnings, as measured by the P/E ratio, is crucial to sharemarket returns.

The following table pieces everything together. The second column shows the progression of returns over 20 years, assuming that they grow at a rate of 3% a year (still only an assumption – not something we can be certain about. Indeed, there are years where earnings have fallen).

The next three columns shows how much investors would be prepared to pay for the earnings generated by companies in that year given different P/E ratios (a P/E ratio of 10, 14 and then 18).

Earnings (assuming 3% annual growth)

Value of Portfolio P/E ratio of 10

Value of Portfolio P/E ratio of 14

Value of Portfolio P/E Ratio of 18

Year 1





Year 2





Year 3





Year 4


$ 78,043



Year 5





Year 6





Year 7





Year 8





Year 9





Year 10





Year 11





Year 12





Year 13





Year 14





Year 15





Year 16





Year 17





Year 18





Year 19





Year 20






When you own shares, you are a part owner of a business/businesses. Thinking about the earnings of those businesses, possible earnings growth and what people might be prepared to pay you for these businesses in the future makes us think of our sharemarket investments as a function of how our businesses will perform over time.

While it has not been a major focus on these calculations, if the P/E ratio of the market is currently around 14 to 15 times earnings, and earnings grow is in line with inflation, then we can expect to see future returns in the order of 6.6% to 7.1% a year above the rate of inflation – which I think would be a reasonable return for investors.