Why Permanent Earnings Yields Are Likely to Be Good Estimates of Future Stock Index

Returns

J. Bradford DeLong, U.C. Berkeley and NBER

July 2008

At the level of the stock market as a whole, the ratio of cyclically-adjusted and normal earnings to
stock prices--the permanent earnings yield--should be a good guide to the market's expectation of the
real rate of return.

Think of it as a Modigliani-Miller result. Firms could pay out all their earnings in dividends and still
keep their companies' productive potential unimpaired--that's what "earnings" means, after all. In that
case, as long as the companies' productive potential is truly unimpaired the expected return is the
earnings yield. When firms retain and reinvest earnings it is because managers see it as
advantageous (to them or to shareholders) to do so. Thus with the appropriate caveats--as long as
there are no big gaps between the required market and firms' internal rates of return, and as long as
current accounting earnings do not grossly understate or overstate true Haig-Simons permanent
earnings--the earnings yield on an index should be a good guide to the market's expectation of the
long-run real rate of return on equities.

To fix this intuition, consider the Gordon equation in a steady-state context. The Gordon equation
relates the long-run rate of return r on a company's stock--or a stock index--to the long-run dividend
yield D/P and to the long-run rate of capital gain g:

r = D/P + g

In steady-state there is a constant dividend yield D/P and a constant share of earnings paid out as
dividends:

D/E = θ

Assume also a simple generating process determining earnings. Assume a constant internal rate of
return r+ρ on reinvested earnings. Earnings are then:

E = (r+ρ)K

where K is the comprehensively-defined productive capital stock assets of the firm (or index), and
where the capital stock increases over time as retained earnings are used to purchase new plant and
equipment or acquire already-existing productive assets:

dK/dt = E-D

In steady-state, the rate of capital gain g will be the same as the rate of growth of the capital stock:

g = (1/K)(dK/dt)

And then it is a simple matter of algebra:

(1/K)(dK/dt) = (1-θ)E/K = (1-θ)(r+ρ)

r = D/P + r - θr + ρ - θρ

θr = θE/P + ρ - θρ
 r = E/P + (1/θ - 1)ρ

For ρ=0--when there is no difference between the market and the internal rate of return--then simply:

r = E/P

For θ=1--when there are no retained earnings--then simply:

r = E/P

When θ is less than one--when there are retained earnings--then earnings yields will understate
returns to the extent that superior managerial knowledge of projects creates a positive gap ρ between
internal and market rates of return; earnings yields will overstate returns to the extent that managerial
entrenchment allows the dissipation of retained earnings on low-return projects--a negative gap ρ.

When firm managers classify investments as operating expenses to reduce tax liability, there will be a
further positive wedge between r and the accounting earnings yield. Should firm managers overstate
earnings to try to boost stock prices to increase the value of their options, this will drive a negative
wedge between r and the accounting earnings yield.

And, of course, these are permanent earnings yields we are talking about: they must be properly
adjusted for the state of the business cycle and for windfalls and non-recurring expenses.

But with these caveats--accounting earnings a good approximation to true Haig-Simons permanent
earnings, managerial entrenchment offsetting superior managerial information to keep internal close
to market rates of return, and so forth--the same logic that leads us to the Gordon equation
conclusion that the dividend yield should be equal to the difference between the required rate of
return and the dividend growth rate leads, if taken one step further, to the conclusion that the
earnings yield should be the required rate of return.