Here is a fun visual way to think about future returns from the equity market.
The future returns from equities are made up of three components:
Earnings Growth: Ultimately this is the most important driver of long term equity returns
Valuation changes (in PE ratio):
* Here we measure for every rupee of earnings how much are we ready to pay (sometimes when the mood is good investors have paid up to 25 times and sometimes when the mood is bad and everyone has given up on equities this metric has gone as low as 9 times).
* This component is simply the reflection of the aggregate mood of all the market participants. It is impossible to predict future valuations as who the hell knows how the mood of investors will be a year down the line (honestly I won’t be able to predict my own mood).
* This component is the most unpredictable one and is the culprit responsible for equities being an extremely volatile asset class
Dividend Yield: This has generally been around the range of 1.5% historically for the Sensex
The future returns of the Sensex = Earnings Growth * Change in Valuations + Dividend Yield
If you are investing at average valuations, then you should expect the future returns to be around the earnings growth (+ dividend yield of 1.5%).
If you are investing at high valuations, then you should expect the future returns to be lower than the earnings growth + dividend yield of 1.5% (as drop in valuations shave of some of the earnings growth from translating into returns)
If you are investing at low valuations, then you should expect the future returns to be higher than the earnings growth + dividend yield of 1.5% (as increase in valuations add returns over and above earnings growth)
What if the valuations at the end of tenure are not equal to the average valuations?
As earlier mentioned, I have no clue on what the exact valuations would be on the last date of your investment tenure. But however, historically Sensex valuations have always mean reverted to 17-18 times at least once in all possible 2 year periods of the last 18 years.
While there is no compulsion that this has to repeat, going by history it is fair to assume that you will get an exit at around 17-18 times in the last 2 years of your investment period.
What should be a reasonable expectation on equity returns going forward?
Current PE ratio: 23.2 (Source: https://www.idfcmf.com)
Assuming it mean reverts to 18 times, this implies a knock of 22%.
That works out to approximately a 5% detraction of returns on an annualized basis over the next 5 years.
Earnings growth expectation:
In order to arrive at our approximate estimates for the next 5 year earnings growth, we need to project these two parameters.
Nominal GDP Growth (i.e Inflation + Real Growth
Corporate Profits as a % of GDP
For nominal GDP growth, let us go by RBI estimates which is around 6-7% real growth + 4-5% inflation = 10 to 12% Nominal Growth
We will assume that the corporate profit as a % of GDP moves closer to the long term average (5% of GDP) over the next 5 years. (to around 3.5% to 4.5% as a % of GDP)
Going by this, our reasonable estimates of earnings growth for the next 5 years can be around 15% to 21%.
Earnings growth can be around 15% to 21% over the next 5 years
Valuations will lead to a negative impact of around 5% over the next 5 year
Thus overall return expectations for the Sensex over the next 5 years can be approximately around 11% to 17%
This being said, given the high valuations at this juncture
We should at least have a minimum time frame of 5 years (with a mindset to extend by 2-3 years if required)
Be prepared for intermittent sharp declines
The idea here is not to predict but just a rough process via which we can set some reasonable expectations on what to expect going forward over a longer time frame.
Remember: The short term as always will be unpredictable and possibilities of a steep fall cannot be ruled out if an external negative event hits given the high valuations
What can go wrong?
As clearly seen a high earnings growth remains the key driver of returns for the next 5 years. Since valuations are already high it will also remove a portion of returns that will actually be provided by earnings growth.
So for the next few years – there are only three things that matter – earnings growth, earnings growth and earnings growth! As always, take this projection business with a pinch of salt. I would love to hear your comments on if I am missing out something. Also please feel free to post your suggestions on how we can improve this and make it a usable framework for all.
Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments