In his book "the investors manifesto", William Berstein explains how to use the Gordon equation to estimate expected real returns on stocks for stocks on the long run.
The Gordon equation reads
Expected return = Dividend yield + dividend growth rate
The expected return is a real return. This means it is corrected for inflation. If I understand correctly, real return = nominal return - inflation.
Dividend yield is dividend of a stock divided by price.
The dividend growth rate must also be adjusted for inflation. It is hard (or impossible) to predict, but between 1870 and 2010 the inflation adjusted dividend grew with 1.32 % per year, on average (see Shiller, http://aida.wss.yale.edu/~shiller/data/ie_data.xls ). This is the number that Bernstein uses.
Now I am wondering three things
- Some companies chose to buy back shares instead of paying dividends. Shouldn't I use the 1 / price earning multiple instead of dividend rate?
- Companies can go bankrupt and the share holder can lose his money. Between 1870 and 2010, for sure some companies have gone bankrupt. Is this effect included in the dividend growth rate of 1.32 %?
Let's calculate expected real returns for some vanguard funds. For the moment we ignore costs. Is this a good comparison of expected real retruns?
Expected return = 1/PE multiple + 1.32 %
Data from https://www.vanguardinvestments.de/portal/site/de/en/mutualfund#funds_tab. PE multiples
Fund Index PE multiple * Expected return Vanguard Emerging Markets Stock Index Fund MSCI Emerging Markets Index 13.3 8.8% Vanguard European Stock Index Fund MSCI Europe Index 20.4 6.2% Vanguard Eurozone Stock Index Fund MSCI EMU Index 23.9 5.5% Global Small-Cap Index Fund MSCI World Small Cap Index 25.3 5.3% Japan Stock Index Fund MSCI Japan Index 14.6 8.1% Pacific ex-Japan Stock Index Fund MSCI Pacific ex Japan Index 16.5 7.4% SRI European Stock Fund FTSE Developed Europe Index 19.6 6.4% SRI Global Stock Fund FTSE Developed Index 18.5 6.7% Vanguard U.S. 500 Stock Index Fund S&P 500 Index 18.8 6.6% Vanguard Global Stock Index Fund MSCI World Free Index 19 6.6%
(*) PE multiples of funds, not of the index.
It should be noted that this is an expectation, and not at all a guarantee. In general, to funds with lower PE multiples are more risky. Expected real return is not a measure of risk.