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February 06, 2005

More Stock Returns

Andrew Samwick wonders:

Vox Baby: Krugman's Unhappy Returns: "The critical assumption in the Baker/Krugman example is that the dividend yield doesn't rise above a number like 3 percent, forcing the capital gains to cover the other 3.5 percent and be reinvested in the corporate sector. What if the payout ratio increased dramatically, so that capital gains accounted for only the same 1.9 percent return that matched the growth rate in profits and the economy as a whole? The inconsistency goes away, as the P/E ratio is stable. So one could rephrase the Baker/Krugman critique as, 'Because of the low rate of economic growth, those holding to a 6.5 percent return are assuming an unrealistically high dividend yield.' But is a high payout ratio (e.g., 50% larger than what Krugman is positing) so unrealistic? I don't believe that economists as yet have a solid answer to this question, largely because they don't have robust models of what determines the dividend payout ratio."

Well, let's put GDP growth at 1.9% per year, earnings of companies in the index growing at GDP growth minus one percentage point, so we have 0.9% annual returns coming from there. If we are to have a total return of 6.5% per year, that leaves us 5.6% per year to come from dividends and stock buybacks. At current earnings yields of 3.8% per year, that means that corporate net investment would have to be negative: businesses would have to be spending almost 150% of their net earnings on cash flowing to shareholders, and running down their capital stocks. That can't be done--not if you want to maintain the profitability of the businesses. Failing to replace your capital that wears out and becomes obsolete is a really bad idea.

Posted by DeLong at February 6, 2005 07:51 AM