John Bogle's two returns: what the business earns, and what the price-earnings ratio adds
John Bogle's way of splitting a stock return into what the business earns and what a change in the price-earnings ratio adds, with two decades that show the second part doubling or halving the result.
Ask a beginner where the stock market's near-18% annual return of the 1980s and 1990s came from. The honest answer is usually that it went up. John Bogle split that return in two.
About 10½ percentage points a year came from dividends and from earnings growing. The other 7½ came from a change in what investors were willing to pay for each dollar of those earnings. 1
The split matters because the two halves answer to different things. The first answers to the company's results. The second answers to what buyers will pay next.
Who & Why
John C. Bogle founded The Vanguard Group and spent his working life measuring what investors keep. 2
As a Princeton senior he wrote his thesis on "The Economic Role of the Investment Company." Fifty-two years later he called that subject one chosen "providentially for my lifetime career that followed." 2
That habit produced arithmetic a beginner can use on any company, whatever they end up owning. The tool needs three numbers: a dividend yield, a view on earnings growth, and the multiple being paid.
From those, a return sorts into the part the business produced and the part the price change produced.
The Core Idea
Investment return is the dividend yield you start with plus the rate earnings grow from there. Both belong to the business. The yield is published; the growth rate you estimate from the company's record.
Speculative return is the change in the price-earnings ratio, the multiple buyers pay for a dollar of earnings. It arrives when buyers collectively decide that the same dollar deserves 30 times instead of 15.
The split follows from how a share price is built. Price is earnings per share times the multiple, so your return is earnings growth plus dividends, plus or minus whatever the multiple does.
Hold the multiple still and the business sets your result. Let it move and the market sets part of it.
How long you hold decides which piece dominates. Across the twentieth century the multiple rose from 12.5 to 30. That rise added only 0.6 points a year to a 10.4% average return. 2
Inside that century, individual decades ran far above and far below that 0.6.
In Their Own Words
Bogle stated the definition in three sentences in a 2005 keynote:
Stock market returns come from just two sources: investment return and speculative return. Investment return is the sum of the initial dividend yield on stocks, plus the subsequent rate of earnings growth. Speculative return is the impact of any change in the price investors are willing to pay for each dollar of those earnings. 1
"Over the long run investment return has accounted for about 100 percent of the market return and speculative return has contributed the remainder—essentially nothing," he continued. "In the short run, however, speculative return matters enormously." 1
At West Point in April 2006 he put the same conclusion in plainer words. "In the long run, stock returns depend almost entirely on the reality of the investment returns earned by business. The perception of investors, reflected by the speculative returns, counts for little." 2
Bogle traced the distinction to Keynes, who in 1936 separated "enterprise" from "speculation," and set it beside Graham's line about the market being a voting machine in the short run and a weighing machine in the long run. 2
The Story That Proves It
In March 2001, with the dot-com bubble collapsing, Bogle compared two twenty-year stretches of the same market in a speech at the National Press Club. 3
From 1961 to 1981, dividends and earnings growth produced 12% a year. The multiple fell from 22 times earnings to 8, costing 4½ points a year. An investor's return came to about 7½% a year. 3
From 1981 to 2001, the business side produced 10% a year, less than the earlier stretch. The multiple climbed as high as 33 and settled near 24, adding 5 points a year. An investor's return came to about 15% a year. 3
Bogle's summary of the pair: "the fundamentals of earnings and dividends were actually a bit lower than in 1961-1981 (10% vs. 12%). But, the annual market return more than doubled, from 7% to 15%." 3
The second stretch is the one in which, as he noted, most American families acquired their investment experience. It taught them that equities return about 15%, while the businesses inside the index were producing 10.
What This Means for You
Bogle measured whole markets. The same three numbers work on one holding.
Write the split down before you buy. Record the dividend yield, your earnings-growth estimate, and the multiple you are paying. Yield plus growth is what the business owes you; anything above that has to come from other buyers.
Turn the multiple into years. A price of 30 times earnings is 30 years of today's earnings, and growth is what shortens the wait.
Bogle's conversion runs the other way too: a 100% rise in the multiple over ten years adds about 7.2 points a year. 2
Give the business part a decade. Bogle measured in decades because over that span the multiple's noise fades and a company's compounding shows through.
Audit your own results the same way. When a holding outruns the growth of its own earnings by a wide margin, the multiple did the work. The same mechanism can take it back.
Where It Breaks
The multiple moves on its own timetable. Asked what it would do next, Bogle answered: "Of course, we have no idea what it will be," and offered his own ten-year estimate as a guess. 1
Growth is the soft number in the sum, and Bogle flagged it as one. Presenting a 6% assumption in 2006, he added: "hardly guaranteed!" 2
The tool was built for an index, where thousands of companies average out. A single company can hold a high multiple for years because the business really did get better. On a single holding, a falling multiple is weak evidence of a market error.
Reported earnings carry whatever accounting produced them. Bogle described the late 1990s as a time of "robust growth in 'operating' corporate earnings (but not without some aggressive earnings management)." 3 A growth rate read off reported earnings inherits the same room for judgment.
The split tells you what you are being paid for. What happens to the multiple next stays with other people.
References
- 1In Investing, You Get What You Don't Pay For (2005)
johncbogle.com
- 2Investment Wisdom and Human Values (2006)
johncbogle.com
- 3After the Fall (2001)
johncbogle.com
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