by the Gordon model. If a firm cuts its dividend dand uses the proceeds
to earn a rate of return r, the growth of future dividends gwill rise by
just enough to keep price of the stock P, unchanged under the lower div-
idend.
The low growth of real historical earnings per share has caused
some economists to predict low future real returns for the stock market.
In 2002, at the bear market low, Robert Arnott and Peter Bernstein pre-
dicted that the current low dividend yield when added to the historical
growth of real earnings will yield future real stock returns of between 2
and 4 percent.^7
But these pessimistic predictions proved wrong because they ig-
nored the impact of the lower dividend-payout ratio on earnings
growth.^8 As noted above, a reduction in the dividend increases retained
earnings, and if the return that management earns of its retained earn-
ings is identical to the return demanded by shareholders on its stock,
then the increase in earnings per share growth will exactly offset the de-
crease in the dividend yield.^9 One must not forecast future real returns
from historical earnings growth rates when the payout ratio has
changed.
FACTORS THAT RAISE VALUATION RATIOS
We have noted that the historical real return on equity has been between
61 ⁄ 2 and 7 percent per year over long periods and that this has coincided
with an average P-E ratio of approximately 15. But there have been
structural changes in the economy in recent years that may change that
ratio.
Two of these changes relate directly to the expected rate of the
return on equities and one to the equity risk premium.
128 PART 2 Valuation, Style Investing, and Global Markets
(^7) Robert D. Arnott and Peter L. Bernstein, “What Risk Premium Is ‘Normal’?” Financial Analysts
Journal, vol. 58 (2002), pp. 64–85. As noted in Chapter 6, Bill Gross from PIMCO (Pacific Investment
Management Company, Newport Beach, Calif.) also used this analysis to predict “Dow 5000” in
September 2002.
(^8) Robert Arnott and Cliff Asness disputed the claim that higher retained earnings means higher div-
idend growth and issued a pessimistic forecast in “Surprise! Higher Dividends = Higher Earnings
Growth,” Financial Analysts Journal, January/February 2003, pp. 70–87.
(^9) A simple example will illustrate the point. If the P-E ratio of the market is 15, then the earnings
yield is 6.8 percent, which is also a prediction of its real return. If the dividend yield is set at 5 per-
cent, then the accumulation of retained earnings will allow the rate of growth of real earnings per
share to be 1.8 percent per year. If the dividend yield is set at 2 percent, then the increase in per share
real earnings will be 4.8 percent per year.