You use the dividend yield and add it directly to the “expected P/E” based on growth rate. But, if the stock price falls then the div yield rises, and so will the fair value P/E you predict (i.e. the stock’s value based on P/E will rise just because the stock price has fallen).

Why would the expected/fair value P/E rise if the stock price fell and nothing else (like growth, risk, etc.) changed?

Thanks.

The recent downturn from the high in October has led to a great deal of chatter about the markets being cheap. That the recent turmoil has presented us with wonderful buying opportunities based on valuation. Readers here know that I disagree, and vehem…

According to this
chart, that is not the case.  S&P’s margins are at all
time high as well.  

I would be more concerned if the profit margins for the SP500 sky rocketed and then reverted back to the mean.

I recently read Leon Levy’s “Mind of Wall St.” and it in he brings up a salient point about the relationship between corporate profitability and the savings rate. Generally, a lower savings rate should produce higher corporate profitability, all else being equal. Because businesses have fixed costs (labor, real estate…), every incremental portion of my income that I spend instead of save should flow through the corporate P/L at a higher incremental margin than operating margins, hence raising margins. As the savings rate inevitably increases from its present 0.2%, it seems inevitable that this must help push margins back down to their historical average.

Caveat: I’m not a macro guy, but Levy’s argument intuitively makes sense to me.

Ryan,

The reason the stock market has returned more than 3% is a combination of things. First, GDP has been adjusted for inflation, while stock market returns have not. The real return (above inflation) has been about 6.5%.

Dividends from stocks account for the majority of the rest (a small amount at todays valuations and payout ratios @ 1.8%. Historically @4.5% of the return) About .9% a year has been the increase in P/E’s and the remainder has been real earnings growth. As you can see, long term real earnings growth has been around 1% above inflation if you do the math. Real earnings have historically grown slower than GDP. That is what you should expect moving forward as well.

Also, what do you think about the prospect of accelerating progress due to technology to keep things “propped up” if you will with respect to your 8.5% mean margins? Do you not think this is a significant effect enough to justify high projected future profits?
Thanks! I just ordered the book, would be very interested to hear your response to my questions.

Thank you for showing the graph with GNP as well.

One other question. Why start at 1980? In the 1960s I believe profit margins were at levels such as the current ones.

Also, the integration of China/India into the global economy could be providing an excess supply of workers that will take a protracted period to efficiently make use of. This could keep worker wages down and slow down the process of profit margins returning to historical norms.

Finally, S&P 500 dividend yields are 65 bps above real government bond yields. Corporate profit margins better collapse quickly or you can’t justify buying bonds over stocks for the medium-term. (Of course one could argue that it will be a low return environment going forward for all assets.)

I like your site and just ordered your book.

Vitaliy