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Interestingly, if over the course of the forecast horizon, they go up and then revert back to where they are today, the effect on the return will actually be indefinitely, or for the length of the forecast horizon.
In that case, the change in valuation will make a net positive contribution to the overall return, which could push the total return well above 5.95%, particularly on shorter forecast horizons where the long-term rise to even higher valuations seems like a lot to ask for.
To answer the question, we need a way to estimate the rates of return that real investment and share buybacks at current valuations can be expected to deliver, respectively.
The following table, which I explain below, is an example of a crude way of using historical data to make that estimate: We start by noting that the return contribution from reinvested dividends is functionally identical to the return contribution from share buybacks.
Similarly, to estimate the historical rate of return that dividends (or share buybacks, which are the same thing) were able to deliver for shareholders, we compare the historical return that shareholders received from reinvested dividends to the average “amount” of earnings that corporations historically used to pay them.
That’s what the table does: it divides the historical return contribution that was received from EPS growth and reinvested dividends, 1.73% and 4.55%, respectively (column 3), by the historical percentages of EPS that the corporate sector devoted to each activity, 40% to real investment and 60% to dividends, respectively (column 2).
In the next few years, the cycle could turn, with the CAPE7 falling back to a trough value of, say, 13.
The CAPE7 could then hover around a value of say 17 to 22 for a decade or so and then eventually return to its current value of 28 in another market boom that peaks right around the end of the forecast period.
We can use these numbers to estimate what the effect on the total return if the corporate sector had shifted the EPS payout towards one source and away from the other.
The current cyclical upturn notwithstanding, capital allocation is likely to continue to shift away from real investment towards share buybacks, which will further contribute to the drop in per share growth, given that the buybacks (and acquisitions) will end up being carried out at today’s very expensive prices.
If a shift from investment to share buybacks does continue to occur, how significant will the downward effect on per share growth rates be?
The only difference is that in a share buyback, the company reinvests the “dividend” for the shareholder, buying shares in the shareholder’s name and thereby eliminating the unnecessary tax event that would have occurred if the dividend were paid to the shareholder in cash and redundantly reinvested in those same shares.
Buybacks are a relatively recent thing in market history, so we can assume that all of the earnings that were historically paid out as dividends were reinvested into businesses.