No. of Recommendations: 27
First, let's assume earnings growth will be the same in the decade ahead as it was in the previous ten years... The overall approach is a sensible top level view.
But this quote is probably the weakest assumption in that chain--net margins can vary a LOT.
They vary both shorter term with the business cycle, and over longer time frame with big changes in things like taxation and the bargaining power of labour, and import competition.
Have a look
https://fred.stlouisfed.org/graph/?g=cShPeriods of rising net margins give rising profit figures, but that dynamic can't be extrapolated.
Fortunately that's pretty easy to correct for.
Rather than using the recent profit growth rate figure to estimate future profit growth, use the recent sales growth rate figure as an estimate of future profit growth.
Of course it should be inflation adjusted to get a meaningful number.
A good thing to remember: Over the long run, profits can't rise any more than sales, because net profit margins can not rise without limit.
We know for sure that if there are normal profit-seeking companies a million years from now their profit margins will not be over 100%, nor less than zero.
It's not a simple cycle, but they have to wander forever in a firmly bounded range from 0% to 100%.
A squishier but more practical view: in the last 75 years US net corporate margins have only rarely been below 5%, and only very rarely above 11%.
The latter figure included last year, which is why I suggest it would be unwise to simply extrapolate current profitability.
FWIW, S&P 500 real sales per index point have risen inflation + 2.2%/year in the last decade and inflation+2.3%/year in the last 20 years.
So for a profit forecast figure, I would try to estimate what today's profits were if this year were neither unusually good nor unusually bad on the net margin front,
then pencil in real profit growth of around 2.2%/year from there.
This gives us a pretty darned good idea what the stocks will be worth in aggregate in future, as value ultimately comes from profits.
The big problem with this is trying to estimate what future market multiples might be for the broad market--we might know their future value but have little idea about their future prices.
The best can do is say something like "if net margins and market multiples resemble their 15 year averages, then market returns will probably be around X%/year from here, after a one-time adjustment of Y%".
But it's a big "if".
You can come up with a super simple rule of thumb, which is really dumb but actually not that bad:
Since dividends historically trend so smoothly, your rate of return buying the broad market, absent any big change in valuation multiples, will be roughly the dividend yield on purchase date plus inflation plus 2.2%/year.
The SPY yield is about 1.55% right now.
Jim
