Economic fundamentals still drive total shareholder return

By Tim Koller with Jelle Duizendstraal, Marc Goedhart, and Vartika Gupta, CFA

Market bubbles and crashes have always captured public attention, fueling the belief that the stock market moves in chaotic ways that are detached from economic fundamentals. The rise and decline of technology stocks between 2020 and 2022, the 2008 financial crisis, the technology bubble of the 1990s, the Black Monday crash of October 1987, the leveraged-buyout craze of the 1980s, and, of course, the Wall Street crash of 1929 appear to confirm the idea that the stock market is an arena where emotions reign supreme. Yet the long view offers a different perspective. The facts clearly show that individual stocks and the market overall tend to track both returns on invested capital (ROIC) and growth over the long term. Over the past 200 years, US equities have delivered consistent returns to shareholders of about 7 percent annually, adjusted for inflation, decade after decade (Exhibit 1).

This return effectively equals the sum of share price appreciation and cash yield (Exhibit 2).

During the past 60 years, the period for which we have the most reliable data, share price appreciation in real terms hovered in the range of 3.0 to 3.5 percent per year, and total cash yields have been around 3.5 to 4.0 percent, yielding total real returns of approximately 7 percent.

Let’s take a closer look at each of these two components.

1.    US corporate profit growth

Share price appreciation can be broken down into two components: corporate profit growth and change in the P/E ratio. US-based companies have generally seen corporate profits grow at an annual rate of about 3.0 to 3.5 percent per year in real terms. As for the median P/E, there has been no significant change when spread over 60 years—the P/E is stable if long-term growth rates, returns on capital, and costs of equity are stable.

2.    Cash yields

The reinvestment rate is equal to the growth rate in nominal terms divided by the return on equity (ROE). With 3.0 to 3.5 percent real growth, 5 to 6 percent nominal growth, and 12 to 15 percent ROE, it follows that the reinvestment rate should be 35 to 45 percent. In other words, corporate America has typically reinvested about 35 to 45 percent of profits every year to achieve real profit growth of 3.0 to 3.5 percent, leaving the remainder to be paid to shareholders as dividends and share repurchases (55 to 65 percent of profits).

Multiplying the payout ratio of 55 to 65 by the inverse of the long-term P/E of 15 to 17 translates to a cash yield on the value of the shares of around 3.5 to 4.0 percent. Adding this cash yield to the annual 3.0 to 3.5 percent share price appreciation results in total real shareholder returns of about 6.5 to 7.5 percent per year, which, for simplicity, we will call 7 percent.

A note of caution

Analysts sometimes miss a critical element of stock returns: Gains are not only a function of share price appreciation but are also impacted by cash yields. From their point of view, share prices cannot increase faster than corporate profits, a perspective that erroneously misses the cash distributions entirely.

Volatile share prices sometimes lead people to suggest that valuations and long-term total shareholder returns are divorced from economic fundamentals. A closer look reveals that the stock market is clearly linked to economic fundamentals of growth and ROIC in the long run.

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