Sunday, December 13, 2009

A Random Walk Down Wall Street: Chapter 12

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, the reader is taken through the last several decades of stock and bond returns, and a method for predicting stock returns going forward is put forth.

Specifically, Malkiel divides the last 60 years into three periods, each of which contained a different set of circumstances that dictated the outcome of stock and bond returns. For example, periods with high unanticipated inflation would see poor bond returns, since bond prices would have to drop in order for bond buyers to receive a rate of return that was higher than inflation. While stock prices are believed to be rather neutral to inflation, history shows that stocks also performed poorly during bouts of high inflation.

The formula Malkiel uses to predict stock returns is as follows:

Stock return = Current Dividend Yield + Dividend Growth Rate + P/E change

The P/E change is the most difficult factor to predict. When the market is optimistic (pessimistic), market P/E's will rise (fall). Over the long-term, however, the effect of this valuation change reduces in significance; but over short periods, this factor can have a dominant effect. The current dividend yield is easily calculable, while the dividend growth rate can be approximated. (Malkiel appears to use recent history to estimate the dividend growth rate, but other methods also exist such as multiplying the market's aggregate return on equity by its retention ratio, the percentage of earnings that the market does not pay out in dividends.)


Anonymous said...

Stock return formula is not correct, since if the dividend yield is growing by 10%, the expected return is not 10%. The 10% is the increase in the dividend, not the increase in return. I would say the stock return is:

cpi+gdp + p / e
cpi = consumer price index
gdp = increase of the global economy or the country
p / e = exchange rate between the price paid and the price it sells, which reflects the ability of directors to grow the FCF, the perspectives of the company, buying euphoria ....

Sorry, I'm using the google translation, I hope you understand me

Anonymous said...

Excuse me, i wanted say Stock return = Current Dividend Yield + CPI+ GDP + P/E change

Saj Karsan said...

Hi Anon,

Your formula is a different one. It does make sense, but I would say it underestimates stock returns because companies in the market tend to have above-average returns compared to the average business.

Malkiel's formula is based on the formula that a market's price is worth the discounted future cash flows: P = D/(r-g) where,
P is price, D is next year's dividend, r is the return, and g is the growth rate of D