According to , the P/E ratio of the S&P 500 is now 35, and the dividend yield is only 1.3%. The all-time low dividend yield was 1.11% back in August 2020. Even if you consider stock buybacks, the earnings yield is less than 3%! That means if corporations all distributed every penny of their profits as dividends, it still wouldn’t be higher than 3%. Before we go any further, I’m not advocating market timing, as people were saying that the S&P 500 was “overvalued” back in 2015 when the P/E ratio was 25 and the dividend yield was 2%. Nobody truly knows what will happen to prices in the short-term.
Even if the P/E ratio seems a lot higher now than the historical average, what has that actually meant? The Morningstar article examines how much of the historical return of the S&P 500 from 1976 through March 2021 was from P/E expansion.
In January 1976, the P/E ratio was only 11.8. In March 2021, the P/E ratio was 31.5. That seems like a huge difference, and over that 45-year time period, it did add 2.2% to the overall historical average annual return. But we also got 3% from earning growth, and another 2.75% from dividends, for a total return of ~8% above inflation. 8% real return!
In a way, this is somewhat comforting, as if you look at the long-term, a shrinking P/E ratio won’t completely destroy your retirement by itself. Instead of adding 2%, it might subtract 2%.
Looking ahead, if you assume a generous 4% from earnings growth, 0% from a constant P/E ratio, and 1.3% from dividends, that’s roughly a 5% future real return. But if the P/E ratio goes back even partly back to historical averages, that will be closer to a 4% real return. The problem is that bonds are giving us 0% real return at best, so I’m sticking with owning productive businesses.
The numbers on my brokerage statements keep going up so perhaps I shouldn’t complain, but I sure hope the earnings start to catch up to the prices soon (as some predict). I like the idea of the P/E ratio going down due to higher earnings rather than lower prices!
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