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Estimating Future Returns With Fundamentals

January 18, 2012 Leave a comment Go to comments

Most planning around investments is based on the current market value. If you want to know what they’ll be worth in the future, you take the current value and apply a growth rate. If you want to know how much you can live off of, you take the current value of your portfolio and apply a safe withdrawal rate. We know that this doesn’t always work (try applying a regular growth rate to the market value in 1999 and estimate where it was in 2009). Projections based on something more fundamental than the stock price might be more accurate. What are the alternatives?

Unless you’re a perfect market timer you don’t really know where the market will go in the future. But can we get a little closer and at least have a warning when standard conditions might not apply? In a way dividend investors have a better model. They know how many shares they own and they project the dividends from those shares, which they can live off of. If the actual share price falls by 50% they can keep collecting the same dividends unless the companies get into trouble.

Can you do this without being a dividend investor? One of the fundamentals in investing is the actual profits that companies earn, which is similar to the dividends they pay. The stock price varies a lot more than the profits. But they do go up and down too, so it might be more helpful to use something like the average of the last 10 years’ earnings.

If you did this you could translate all kinds of rules using a consistent P/E10 ratio. For example if you wanted a withdrawal rate of 4% and you estimated a normal P/E10 ratio of 12, that would mean withdrawing 48% of the 10-year average earnings. In fact this looks like a good result since a company that pays 48% of its profits in dividends would seem pretty safe. If you planned to retire with a portfolio of $1m and withdraw $40,000 per year this could give you a warning signal if you reach your desired portfolio size but the earnings aren’t high enough yet because stocks are overvalued.

Using this could prevent you from getting too optimistic when stock prices are high or underestimating future returns when they are low. But it does ignore one important signal. If you’re getting income from your portfolio it doesn’t show that it can be worth spending more when the prices are high and less when they are low.

If you’re interested in getting a view based on long-term stability this might be one way to get it. It would be good to see some research on whether it would help avoid costly mistakes in historical scenarios.

Do you look at your investments in different ways to see where they are going?

  1. January 19, 2012 at 6:11 pm

    That is a really good argument to invest in dividend stocks for retirement. Dividends really can be a tad easier to predict than the stock market ๐Ÿ˜›

    • January 19, 2012 at 9:54 pm

      Indeed that makes things simpler ๐Ÿ™‚ I just want to be more diversified.

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