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Jeremy Siegel, Ph.D. The Future for Investors

Jeremy Siegel, Ph.D., The Future for Investors

Yes, Stocks Are Dirt Cheap

by Jeremy Siegel, Ph.D.

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Posted on Monday, December 1, 2008, 12:00AM

I knew that my last article in Yahoo! Finance, “Why Stocks are Dirt Cheap,” would elicit strong opinions, but little did I imagine how controversial it would prove to be! The column attracted comments ranging from “Off with his head!” to “Bravo!”

 

The article also attracted considerable attention from finance professionals. Henry Blodget disagreed with my analysis, stating that other well-known financial analysts, such as Jeremy Grantham, John Hussman, Andrew Smithers, and my good friend Robert Shiller of Yale University, put fair value of the S&P 500 Index around 1000, far below where I think it should trade. Ned Davis Research, a well known and respected research firm, also took exception to my earnings estimates.

 

I have nothing but the highest respect for all these individuals and I believe their work must be taken seriously. But I believe their criticisms are wrong and here I explain why I get a significantly higher fair value estimate for stock values than they do.

 

Trend Earnings

 

In last month’s article, my fair-value estimate for the S&P 500 Index was derived from a “normalized” earnings of $92 a share for the S&P 500 Index times a 15 average price-to-earnings ratio for the stock market. “Normalized” earnings are earnings stripping away the effects of business cycle, so that normalized earnings are higher than actual earnings in recessions, such as now, and lower at the top of booms. Currently, Standard and Poor’s is projecting that operating earnings for the S&P 500 Index in 2008 will be $64.14 while reported earnings, which contains very large write-offs from a few firms, are at $49 per share.

 

My estimate of $92 for normalized earnings drew considerable criticism, partially because it was based only on earnings over the past 18 years. If one looks at considerably longer-term time spans, some believe the trends forecast much lower earnings. 

 

The farthest back we have historical earnings is 1872, based on valuable data that Prof. Robert Shiller brought to light in his book Market Volatility, published in 1989.  These historical data are based on splicing together data from Standard and Poor’s that goes back to 1928 to earlier data compiled by Cowles Foundation researchers.

 

The graph below depicts those earnings per share data for the US stock market from 1872 through the present, corrected for inflation. Looking at this graph, it certainly appears that earnings over most of the past 20 years have been far above average and that these earnings may now correct to the mean of only $56.40 per share, not far from reported earnings projections this year.  If we apply the historical P-E ratio of 15 to $56.40, we get a projected level of the S&P 500 Index of only 840.

 

Flaw in Analysis

 

But there is an important flaw in using a single trend line to project the future.  Doing so assumes that there has been a constant growth rate of real per share earnings over the entire period, an assumption that depends, among other factors, on an unchanging dividend policy of firms.

 

Yet dividend policy of firms has changed dramatically.  The ratio of dividends paid to earnings, called the payout ratio, has dropped significantly over the past thirty years.  The decline in the payout ratio has substantially boosted the growth rate of earnings per share.  Failure to take this into account will result in a serious underestimate of trend earnings.

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The table below confirms that the fall in the payout ratio has boosted earnings growth.  The shift in dividend policy took place in the early 1980s when firms, because of  liberalized rules for share repurchases, taxes favoring capital gains, and the proliferation of management stock options, reduced the amount of earnings paid out as dividends.  The average payout ratio before 1982 was 64.7%, about 40% higher than the 46.6% payout ratio after 1982.  As the payout ratio declined, the dividend yield declined and the growth of earnings accelerated. 

 

Finance theory predicts, and historical data confirms, that if a firm pays a lower proportion of its earnings as dividends, then these unpaid earnings must be used to either repurchase shares, lower debt, or invest in capital.  In any of these cases, per share earnings growth will increase.


Table 1. Selected Stock Market Variables
Financial Variable 1871-2007 1871-1981 1982-2007
Payout Ratio 61.2% 64.7% 46.6%
Dividend Yield 4.52% 4.96% 2.66%
EPS Growth 1.56% 1.41% 4.5%

 

A higher rate of earnings growth from lowering the dividend does not imply that investors obtain a higher return on their investment when management lowers the dividend payout.  The return to shareholders is the sum of the dividend yield and price appreciation.  On average, a dollar of retained earnings will yield investors a return that compensates the investor for the lost dividend income.  But dividend policy will impact earnings growth.

 

A higher rate of earnings growth also means that using “smoothed” earnings, derived by averaging ten years’ of past data as Prof. Shiller and others advocate, will yield a distorted valuation of the market.  If earnings growth has accelerated, the average of the past ten years will result in a greater underestimate of earnings in more recent decades.

 

Look back at the long-term chart again.  A new trend line has been drawn covering the period of faster earnings growth that occurs after 1981. According to the new trend, the normalized level of 2009 earnings is a far higher $87.66 than predicted by the single trend line. This earnings figure is slightly below the $92.00 that I estimated in my previous article using analysis over the past 18 years, but it is not appreciably different.

 

If we apply a 15 P-E ratio to $87.66 level of earnings, we get a fair value of the S&P 500 Index at 1315, almost 50% above the level the market closed on the Wednesday before Thanksgiving.  Furthermore, with the ten year government bond rate falling below 3%, we are in the lowest interest rate environment we have had over the past 50 years.  Normally, when interest rates are this low, stocks sell for a higher-than-average P-E ratio.  To obtain 1380 fair value of the market that I estimated last month, the P-E ratio would need to be less than one point above its long run average of 15.

 

Objections to My Analysis

 

Some analysts, such as Robert Arnott and Peter Bernstein have claimed that earnings do not grow faster when the payout ratio is reduced since the retained earnings are wasted on unproductive investment and excess executive compensation.  Yet the higher earnings growth from 1981-2007 contradicts their objections.

 

Others may object to my use of “operating earnings” rather than reported earnings, in making my projection. Operating earnings exclude some of the big write-offs that arise from restructuring, pension revaluations, impairment charges, and portfolio losses, although they do include many of the recent write-offs of financial firms.

 

Although operating earnings are only reported back to 1988, the earnings data before that date are, according to sources I have contacted at Standard and Poor’s, closer to the concept of operating earnings than reported earnings.  This is because FASB has sharply increased the number and type of charges that firms must write off and this has depressed reported income, especially during recessions. 

 

Other Distortions in Earnings Data

 

The increasing number of large write-offs has also led to a distorted look at the earnings levels for the S&P 500 Index.  In another article, I have discussed how there are major distortions in the official earnings numbers provided by index providers like S&P. Six firms (AIG, Wachovia, Sprint, GM, Merrill Lynch, and Citigroup) with over $170 billion dollars in losses over the past year, lowered aggregate earnings on the S&P 500 Index by nearly $20 per share.  Yet these firms are tiny and represent less than 1% of the S&P 500 by weight. That is to say over 99% of the S&P 500 had earnings that were closer to $70 per share when the officially reported results are more like $50 per share.

 

I have proposed a new method for calculating earnings for the index that more logically takes into account the weight of each firm in the index when considering their earnings or losses. Using a weighted average method for estimating earnings for the S&P 500 index, I find that trailing 12-month reported earnings on the S&P 500 are closer to $78 per share and operating earnings are $83, despite the economic slump.  Using the $83 figure and my 1380 fair value estimate of the S&P 500, would give only a 16.6 times P/E ratio, a conservative valuations given the very low interest rate environment.

 

Bottom Line

 

I maintain that the stock market is significantly undervalued even when you use very long-term trends to analyze earnings growth. Moreover, the officially reported results are understating the true profitability of the market. The low level of stocks today is not a result of investors expecting current depressed levels of earnings will persist, but rather a result of record risk premiums in the debt and equity markets. When these extraordinary risk levels return to normal, we can expect much higher stock prices.

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  • __A_YAHOO_USER__ - Sunday, March 8, 2009, 12:34AM ET  Report Abuse

    • Overall: 1/5

    looser

  • Yahoo! Finance User - Wednesday, February 18, 2009, 1:59AM ET  Report Abuse

    • Overall: 2/5

    If this guy is an advisor to WisdomTree like the wikipedia article on him says, what does that say about the wisdom of WisdomTree? Do you think they will survive? Get this, the WisdomTree website is still touting the benefits of dividend paying stocks--as if they cannot be cut or eliminated in a bid for survival. Did Mr. Siegel tell them to put that sucker bait on their web site? The stock market is undervalued!! HA HA HA!

  • Yahoo! Finance User - Friday, December 26, 2008, 10:14AM ET  Report Abuse

    • Overall: 1/5

    Just remember that this is the same guy who last year said the S&P 500 would be up 8% in 2009, and also predicted the presidential race would be between Hillary Clinton and Rudy Gulliani. Jeremy Segel might be a college professor, but his predictions are as worthless as everyone else's. Don't give up your day job Jeremey!!!!

  • Yahoo! Finance User - Tuesday, December 23, 2008, 6:35PM ET  Report Abuse

    • Overall: 1/5

    Well, its okay, i own a few gas stations , and I dont' give a damn what you others think. C-stores are recession proof. My annualized revenue for the next 12 months has only fallen 10% as compared to the boom years(after 2002). And i still am bringing home 60k on average from each store. My annual income is still about 300k/year. I paid a multiple of 4 to earnings for these stores. MY POINT IS, YOU PEOPLE NEED TO THINK LIKE BUSINESS MEN AND NOT PAY SUCH HIGH MULTIPLE FOR STOCKS. America is not going to grow as much like it did before for the last 60 years. It has reach its peak. Invest in foreign emerging economies. Not here.

  • joe - Friday, December 19, 2008, 5:34PM ET  Report Abuse

    • Overall: 5/5

    cool

  • Sam - Tuesday, December 16, 2008, 11:12PM ET  Report Abuse

    • Overall: 5/5

    Absolutely right: the cost of capital makes for profitability. We have a systemic problem which when resolved will result in a higher valuation level.

  • USA P - Monday, December 15, 2008, 11:15PM ET  Report Abuse

    • Overall: 3/5

    not bad of article actually for yahoo standards...depending on each individuals' financial circumstances, stocks are poised to be bought for long term investing for the next couple of years. From my own personal observations on how Wall Street works, the best time to make money for the average investor is during bear markets. Bear markets are indication that the real free market is demanding correction while Bull markets tend to be based on hype, fraudulent accounting, corruption, cheap credit, and other false data. But in order to make good judgments, YOU CANNOT DISCRIMINATE INFORMATION NO MATTER THE SOURCE. That includes looking you conspiracy financial news. Do it! Learn how the federal reserve banking system really works, then go make a some money!

  • Asian observer - Sunday, December 14, 2008, 4:16AM ET  Report Abuse

    • Overall: 1/5

    Cheap will become cheaper. See you in Dec 2009 when there will be better buys

  • Dividendman - Friday, December 12, 2008, 11:14AM ET  Report Abuse

    • Overall: 5/5

    Good food for thought but incorrect assumptiont lead to incorrect conclussions: Dr. Siegel assumed Total Return= Current dividend yield stock price increase Instead the truth is Total Return=Current dividend yield Average dividend growth That should be the departing point. I suspect that if Dr. Siegel started from there, he would reach a different conclussion

  • Christian - Thursday, December 11, 2008, 4:30AM ET  Report Abuse

    • Overall: 2/5

    Fair analysis, but not complete. Using your own - or rather Prof. Shiller's data I have to say that: 1) Your main logic is based on the fact that the dividend payout ratio is substantially lower since 1982 than it has been before. Correct, but what is also correct is that this payout ratio has bottomed between Feb 2006 and June 2007 at ~31% and since risen to ~57%. The median value of payout ratios since 1871 to today is 58%. Who knows, it may rise even further in future, though not until the recession is gone. 2) you use operating earnings rather than reported earnings for the calculation of the "fair" value of the S&P 500. The difference between the two is substantial. Let's hear what Jeremy Grantham, Mayo, Van Otterloo (GMO) had to say in August 2006: "Generally, operating earnings differ from net earnings in that operating earnings exclude discontinued operations, extraordinary items, and the cumulative effect of accounting changes. Since investors are a forward looking group, operating earnings should, in principle, be a better guide to future profits than GAAP earnings. In principle, one-off events are about as likely to be positive as negative for a company, and operating earnings would be as likely as not to be less than net earnings. However, this is not what history has shown us. In 1988, operating and net earnings were almost the same. Over each proceeding period, the gap has grown, and in the past four years operating earnings have averaged a full 20% higher than net. Operating figures are taken more or less at face value. Almost every strategist on Wall Street uses operating figures when calculating the P/E ratio of the S&P 500. Wall Street has another trick up its sleeve: valuing the market on next year’s forecast operating earnings. On average, forecast earnings overstate what eventual operating earnings will be by about 10%, and they are always higher than trailing operating earnings, let alone trailing net earnings. The average operating earnings growth since 1988 has been 3.5% real, and the average forecast operating earnings growth has been over 13% real. A P/E on next year’s operating earnings would therefore be using an earnings figure likely to be at least 30% higher than the trailing net earnings, which is the only long-term earnings series available for the S&P 500." As you mentioned yourself in your article ... "these earnings may now correct to the mean of only $56.40 per share, not far from reported earnings projections this year. If we apply the historical P-E ratio of 15 to $56.40, we get a projected level of the S&P 500 Index of only 840." Yours truly

  • Henry - Monday, December 8, 2008, 10:22AM ET  Report Abuse

    • Overall: 1/5

    How very sad when a respected academic resorts to data mining in an effort to salvage a losing argument and failed forecasts. The truth of course, lies in Table 1 which Professor Siegel has helpfully provided and which clearly demonstrates that whether firms are choosing to payout profits in the form of dividends or reinvesting these profits to grow future dividends, the sum of these two variables (DIV/Price g) equals 6-7% which is the same as the long-term return to common equity. If one goes back to 1950 (the bottom of a secular bear market) and calculates a 6.5% annualized compound return on the S&P 500, fair value today would be 655. That's where we're headed Professor.

  • Greg - Saturday, December 6, 2008, 9:54AM ET  Report Abuse

    • Overall: 1/5

    Very poor reasoning. You assume a correlation must mean a cause-effect relationship. The basis for your theory is that a lower dividend payout ratio leads to improved earning growth. You state: "Some analysts, such as Robert Arnott and Peter Bernstein have claimed that earnings do not grow faster when the payout ratio is reduced since the retained earnings are wasted on unproductive investment and excess executive compensation. Yet the higher earnings growth from 1981-2007 contradicts their objections. " It is true that earning growth during the years you mentioned was higher than in the past, and this time period did see a reduction in the dividend payout ration. But how can an academian like yourself assume a cause-effect relationship? There could be many other variables that account for the increased earnings growth which are completely unrelated to the dividend payout ratio. For example, during the time that you cite, interest rates decreased substantially. In fact, the decrease in interest rates is a far more likely contributor to the outsized earnings growth rate.

  • chief - Friday, December 5, 2008, 10:44AM ET  Report Abuse

    • Overall: 3/5

    I see your agrument Professor Siegel however deflationary environments bring down prices. Who owns a cristal ball saying when this economy will re-inflate again?

  • Jerry - Thursday, December 4, 2008, 11:27PM ET  Report Abuse

    • Overall: 2/5

    what if the company raising their dividen policy? why would they raise their dividen policy? well....maybe they want to make their stock more interesting for the market by raising dividen...

  • Hector - Thursday, December 4, 2008, 9:24PM ET  Report Abuse

    • Overall: 5/5

    All the 1* commenters are desperate shorts or longs to be.

  • r - Thursday, December 4, 2008, 6:52PM ET  Report Abuse

    • Overall: 1/5

    This guy is another thumb-sucking optimist. Mistrust rules the markets, and rightfully so. The S P deserves a PE of 4.

  • hans - Thursday, December 4, 2008, 1:30PM ET  Report Abuse

    • Overall: 1/5

    he's been bullish all the way down. He also doesn't take into account that no company can predict their earnings. Ask Mr. Buffet. The reported earnings for the S&P '09 could be $40. And with a pe of 10 and the publics dislike of stocks, it could be a huge drop. He's just guessing like everyone else, but if you take into account his record, you'd ignore him.

  • dirt - Thursday, December 4, 2008, 11:00AM ET  Report Abuse

    • Overall: 1/5

    Does this guy actually follow his own advice?! - he'd be in the poor-house by now or selling apples on the street. I thought 2000 would have wiped him out. Those who can ... you know ? Like Ben & Dave said, if investment isn't done in a business like manner, you will probably lose. People who deal in aggregated data are technical analysts, not intelligent investors. People who study the individual securities of corporations based on the corporate filings look at the professor and smile knowingly.

  • Kevin - Thursday, December 4, 2008, 9:15AM ET  Report Abuse

    • Overall: 1/5

    Nice theory. In practice though, the doc is down 50% and still bleeding. Do all the number crunching you want. Stocks are worth what people are willing to pay. Most folks have no clue what you are talking about. the fact is there is a shadow banking system that the doc ignores, this banking system has trillions in derivatives that have no value and are creating havoc in the world financial system. They are the rottenness that is bringing down the markets. Housing is still grossly overpriced. prior to 2000, you would qualify for a mortgage worth 3x to 4x your annual income. take a look around you and tell me the housing prices are being supported by wages. there is a 125 year correllation chart for that too. For all the historical data presented here, the doc needs to look at the last time in history we allowed a shadow banking system to develop that now holds trillions in worthless paper. then we can make some extrapolations. The answer? It has never happenned before, this situation of the shadow banking system. There is no historical precedent to use. The doc will lose his shirt in the market as it vaporizes and will continue to promote stocks according to the above kinds of analysis that simply ignore the huge elephant in the room.

  • BalintK - Thursday, December 4, 2008, 7:23AM ET  Report Abuse

    • Overall: 2/5

    Dr. Siegel is an accomplished academic. Unfortunately, he is using his methods and models rigidly. I would be more than happy to see him proven right. However, unfortunately, there is a strong chance that he will not only be wrong, but his reputation as an expert will be seriously damaged by going out on a limb. Probably it matters very little: I guess he will not lose his job by giving bad advice - like Jim Cramer of CNBC (of "they know nothing" fame) is still on the air after having called the market bottom in the summer. Dr. Siegel can always cite as an explanation that it was a moral obligation not to add to the deflationary psychology of the market because of the self fulfilling prophecy nature of such forecasts by experts. Maybe he should also reach then the conclusion that it would be a moral obligation to withdraw from making money as a columnist. Well, Dr. Siegel, I am watching the market and your reaction (shunning or accepting responsibility for your column).

  • Yahoo! Finance User - Wednesday, December 3, 2008, 8:35PM ET  Report Abuse

    • Overall: 1/5

    Number crunching works until it doesn't. Lack of morality will sink this market (not to mention lack of leverage).

  • Dan - Wednesday, December 3, 2008, 5:26PM ET  Report Abuse

    • Overall: 1/5

    The REAL reasons for stocks being cheap is that A:) American CEO's are about as accountable as Richard Nixon was as President. That is a NO brainer. B:) This economy that is driven 74% by consumer spending has for all intensive purposes...collapsed, and just wait until after the holidays to see many retailers begin to close stores on a large scale to find this to be true. C:) The Financial Services industry has done a great job of selling a "pig-and-a-poke" over the past 8 years of the current Presidential Administration. With the idea that the Dow was going to stay above 13K, with the way the credit markets were beginning to tighten is a joke. D:) The implosion of the mortgage industry with all the mortgages and loans given on blind faith alone was going to destroy stocks. Especially when debt is traded on the markets. This was a recipe for disaster, that should never had happened. We learned NOTHING from history, and got it right between the eyes. E:) The dollar, and it's fluxuation, and value therein was never good enough to have stable, sustainable growth, especially when this country's manufacturing industry lags well behind other countries, and that the middle class consumer is what makes stocks rise at sustainable levels. Without which, the markets are basically there for bottom feeders, looking to make a quick buck and run. BOTTOM LINE: Regardless of the statistics, the current period of time is hardly a time to be going after cheap stocks (unless you are a Warren Buffett). Unless housing/real estate markets come back together, the markets will be equivalent to the early 80's where you can gamble for a quick buck and pull out. Sustainable growth is STILL far, far away, and unless The Big 3 in Detroit can get a decent useable bailout, and use it in a fashion puts forth vehicles of the future, this economy will be doomed, and the markets WILL crash. The idea that the markets are supposedly undervalued, is an absolute joke. They are STILL WAY OVERVALUED for this time in history. In the 1990's, it was referred to by that crumudgeon Greenspan, that the markets were being moved by "irrational exuberance". At that time the markets went up to where they are today on the creation of the internet. Now we have the internet, and the history since it's creation has seen many dot.coms fail, large numbers of mergers, and an economy that is failing as we speak while the bottom feeders have their way. Does that sound like that this market is "undervalued"? I think not, and with all the bad news ahead, there is more value to be lopped off in the coming months, that will really tell us if this economy can survive in this country, let alone the stock markets. The Monday Morning quarterbacks that Yahoo, if any idea...still don't get it, and are scared, and living in denial. Regardless of statistics, the ill winds blowing in this period of time is hardly indicative of better times ahead for the markets. Hardly a time for growth towards to the value of markets, or the economy in general.

  • Yahoo! Finance User - Wednesday, December 3, 2008, 3:07PM ET  Report Abuse

    • Overall: 5/5

    Good article and analysis. For the doomsayers out there, (and there are always doomsayers - no matter how good or bad the economy) there is over four trillion dollars currently sitting on the sideline in money markets. With interest rates at near historic levels, once things settle down and credit starts flowing again, and it will, that sideline money will start to re-enter the market and will gradually bring the market back into line with its value. Investors are not going to be willing to earn 2% on risk free for an extended time if the market is selling at 10X earnings. One of the things that the doomsayers are ignoring is that corporate america is sitting on top of huge sums of cash. I read recently that there are 400 companies in the Russell 2000 (20% of the total) that have more cash per share than their stock is selling at. Those companies are going to be looking for places to invest that cash, and that will take the form of stock buy backs or new investments. Either way, per share value is increased.

  • Yahoo! Finance User - Wednesday, December 3, 2008, 2:56PM ET  Report Abuse

    • Overall: 1/5

    Wake up, Jeremy - things have changed. CEO's are no longer held accountable. They make up numbers to prop up stock prices, then get bailed out by taxpayers when people finally wake up to their bogus numbers. They are now thinking: "just get us past this mess with some bailout money, so we start making up numbers again, and set our golden parachutes," and you are falling for it. It's time to end the lies, let them go bankrupt, cut their bonuses and pensions. Only when shareholders interests are elevated above management and unions, will things get any better.

  • Richard - Wednesday, December 3, 2008, 2:43PM ET  Report Abuse

    • Overall: 2/5

    Yeah, I guess. I've been making a killing selling short recently. Until I start seeing technical trending in the "Long" direction I think I'll set your article aside.

  • Nandan - Wednesday, December 3, 2008, 12:19PM ET  Report Abuse

    • Overall: 1/5

    DJIA will be somewhere above 5,000 but well under 6,000 around Christmas 2009. Ford will fold. Chrysler will buy out GM. AT&T will be out of the phone business and heavily into the cable TV business. Major players in non-manufacturing industries will fold or merge with smaller (not larger) companies. Social Security and unemployment benefits will be close to zero. Credit cards will be available only to people with at least $100,000 cash in the bank (in a CD, not Money Market). People will be out of cars and in trains/buses. Prices of mansions wil go through the roof. For the rest of us, home prices will decline but nobody will be able to buy new homes because nobody will have any money. Medical, legal, business and engineering degrees will become very unpopular very fast. Instead, people will focus on fashion, computers (software, not hardware), social sciences, and language-acquistion. Service industry jobs will focus on "physical" stuff -- transportation, teaching (hands-on, basic skills), lawn-mowing, baby-sitting, etc. Customer-service reps, financial analysts, research scientists, etc. will be out of jobs. People will live closer together in well-knit communities. Divorce rates will plummet. Violent crime will go to nearly zero. Drug-dealers will go out of business. The size of security forces (CIA, FBI, police, army, etc). will decline dramatically (maybe to 20% of current levels). Terrorism will decline. International borders will change. Monetary and financial systems will be totally transformed -- we will be looking at continents, not at countries, though each country will continue to keep its own government and political system. The world is set to change. We will re-boot and start from the ground up -- worldwide.

  • Robert - Wednesday, December 3, 2008, 12:09PM ET  Report Abuse

    • Overall: 2/5

    Whether the company distributes its earnings as dividends or through a share repurchase should have no effect on the total value of the company's equity (absent tax differences between dividends and capital gains). Professor Seigel has shown that dividend distributions have declined since 1982, but this doesn't mean that the total distributions (dividends plus share repurchases) have declined. In fact, given the dramatic incresase in share repurchases since 1982, it is not clear whether total distributions (as a percentage of earnings) has increased or decreased in the last 25 years. But even if a higher proportion of corporate earnings are reinvested back into the company, that doesn't necessarily mean that the company should be more valuable. Take a simple example of a company that generates earnings of $100 per year, pays all of its earnings to shareholders as a dividend, and has a cost of capital of 10%. This company will sell for a total value of $100/.10 = $1,000, have a PE ratio of 10x, and generate no future growth in earnings. Now assume that this same company starts to reinvest 60% of its earnings each year in investments that earn the cost of capital of 10%. This company will now grow its earnings by 6% (.6 x 10%) annually, but its total value will still be $1,000 and its PE ratio will be 10x. This is because the investments made by the company have a zero NPV. The point of this example is to illustrate that reducing a company's payout ratio (increasing its reinvestment rate) only adds value if the new investments earn a return that is higher than the cost of capital. So even if companies have been investing a higher fraction of their earnings since 1982, the value this will create depends upon the return that these investments can generate. Given the current valuation of the market, I think there is skepticism among investors about the productivity of capital investment in the future.

  • John - Wednesday, December 3, 2008, 11:45AM ET  Report Abuse

    • Overall: 1/5

    What irresponsible jibberish! The professor's "Ego-Glass" is Half-Full and he has concockted a statistical argument that will not, does not and can not apply to the investment life as we know it going forward. We have been fleeced by pencil-whipped financial statements, borrowed too much money and can't borrow anything now. Let's not even get into higher corporate tax rates coming. Just look at GM's balance sheet. Why have GM's problems been swept under the rug for so long? The company needs to go broke - save the taxpayers! OH - we may have a Grand Bear Market Rally but who gives a crap! Who is kidding WHO? Do You trust Your money in this market at this time? Dirt Cheap? I don't think so!

  • Luke P - Wednesday, December 3, 2008, 11:45AM ET  Report Abuse

    • Overall: 5/5

    Very good methodical thinking, all spelled out. Thank You.

  • nyg - Wednesday, December 3, 2008, 10:26AM ET  Report Abuse

    • Overall: 1/5

    Everyone promises the sky. Great profits to follow. Sorry, we do not believe the cover-up explanations for past and current misinformation. Maybe you should try getting a real job and do some honest work !!!

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