S&P 500 Returns: According to an Earnings or the Gordon

                                        Dividend Models


               “Valuation is the central concept of finance. While investors believe that the

                 process is difficult and fraught with errors and assumptions…valuation

                (ought to be) approached with rigor and care. Without methods to assess

                 value, capital budgeting (investing) becomes impossible.” 

                                                                                                                          A Quote


It is a great advantage for investors to be able to directly compare the return of bonds in actual markets to the return of the S&P500, a portfolio of stocks. We suggest a simple assumption, applicable to large companies, that converts reported operating earnings according to GAAP into cash flow. The simple assumption is this: annual capital expenditures (a cost) approximately equalsannual depreciation (an expense). This simple assumption converts earnings into cash flow, that can then be used to value the S&P 500.

S&P 500 Operating Earnings


Standard & Poors publishes detailed earnings estimates of the S&P 500, that is used in finance as a diversified reference portfolio. Crucial to this, that we show in Table I, is the distinction between “operating” and “as reported” earnings. One would normally think of “operating earnings” as the direct costs on the factory floor of producing goods, excluding corporate overheads such as interest paid on debt, marketing costs, r&d and so on. However, the intent of the S&P definition is to exclude only extraordinary items such as fixed asset writedowns and gains or losses on the sale of assets. This enables the summation of diverse company results into a single figure, S&P 500 operating earnings that includes the cost of leverage.


For large companies, yearly capital expenditures approximately equals annual depreciation. Therefore S&P 500 operating earnings approximately equals S&P 500 cash flow available to shareholders. This emphasis on cash flow is crucial, because it also enables the assumptions of company level corporate finance to be applied to the valuation of the S&P 500. We can then simply capitalize annual S&P 500 operating earnings.


The Operating Earnings Yield Model


But how? Remember that the duration (payback) period of a stock is approximately 36+ years. This implies that in a fluctuating economy, one year earnings results, which we will also discuss later, are less accurate than some form of long-term average. In 1988, Yale economist Robert Shiller published “Stock Price, Earnings and Expected Dividends.” Campbell and Shiller found, “Long historical averages of real earnings help forecast present values of future real dividends (i.e. stock prices factoring out inflation).” Thus, as we showed in our detailed 7/1/20 post:


Calculated Level of the S&P 500 a/o 8/22 for a 7% annual return:   P =  (10 year average operating earnings/annual return) X 1.33


                                  Ps&p 500 = (135.77/.07) X 1.33 = 2580


As we shall see, a 7% annual rate of return is what is reasonably required to compensate investors for the long-term risk of investing in equities.


The Gordon Model


It is a tenet of corporate finance that the total value of the company to shareholders equals the present value of the stream of dividends it produces, discounted at the rate of return required by investors (a cost of equity capital to a company). For companies with a constant growth in dividends, the Gordon model discounts those dividends back to the present. Thus:

                                 Ps&p 500 =   __kE__     =   .3573 X 220.53/(.07-.04) = 2626    

                                                   ( r – g)


 P = price  

 k = the dividend payout ratio=.3573 per NYU Stern School S&P statistics 2000-2020.

 E = S&P operating earnings=220.53 per S&P report, Table I. Calculated dividends = $71.64. Actual dividends = $64.80                                         

 r  =  the rate of return of the investment=7%

 g =  the rate of growth in dividends (earnings)=2% real + 2% inflation


We first encountered this model in a stock market course; it struck us as very difficult to implement because what do you assume for (r), what do you assume for (g), and where do you find (k)? What this model requires is an interpretation in context, and that context is the realities of corporate finance. As in the above, we assume for economic growth 2% real and 2% inflation and that investment rates of return should be a 1% markup over the 10 year bond rate of return.


At a 7% rate of return, the two models are within 1.8% of each other. We prefer the first model because it is not dependent upon current dividend statistics. The dividend may be cut, as it was in 2009, in the event of a severe recession. Both models show that the current 8/1/22 level of the S&P 500 = 4118 is very unrealistic.


The Context of Markets


Both present value models need to operate within the context of the economy and markets. On 8/2/22 here is how equity looks according to the first model:


                  Logical Expectation 8/1/22                              Actual Market 8/1/22 *

                          2%   Policy Rate                                                 2.33%                          

                          2%   10 year treasury premium                            .27%

                2%    BAA corporate bond premium                  2.38%

                          1%*  Equity risk premium  (S&P 500=4118)   (.60%)

                          7%                                                                      4.38%

In response to Fed policy rate increases, the 10 year treasury is beginning to invert; and market traders (and computers) are buying the dips. Markets are apparently assuming a return of the low interest rate, low inflation, low growth environment of the past. The Fed policy rate is currently way below the current 5.90% rate of inflation in the core CPI, that excludes food and energy.**


*This is a very nuanced point. We have a moderate distrust of the economic model propounded by economists, which essentially assumes some form of economic equilibrium, and therefore no markets. As a value investor, what is more important is to know what is happening in actual markets and then to concern oneself with the “right” price at which to act. 1 A NYT 8/25/22 article states this point well in relation to climate change. “…the field is learning that simply tinkering with prices won’t be enough as the climate nears catastrophic tipping points (our note: i.e. economic regime change) like the evaporation of rivers (around the world), choking off whole regions and setting off a cascade of economic effects….Experts working on climate change issues say there are plenty of ways for economists to help. For example, the damage from climate change is often specific to geographic characteristics like topography, soil quality, tree cover, and the built environment. Building on those granular factors to identify systematic risks may be more useful for policymakers than broad, top-down economic models.”



1  At a certain level, business contains a great deal of common sense. First, you decide if you want to do it; and then you talk about the price. Some people should learn, its not the reverse.


** This risk premium refers to a diversified portfolio of stocks.