Valuing the Whole Market

Why this matters

Many investors own the market through index funds, not individual companies. For them, the valuation that matters most is the market's. It can't be controlled, and it shouldn't drive frequent trading, but it shapes what a reasonable expectation looks like. Someone planning for retirement on the assumption of 10% a year needs to know when that assumption is generous.

Where the market's return comes from

Over any period, the return from owning shares has three parts.

1. Dividends paid along the way.
2. Growth in earnings per share. If earnings double and nothing else changes, prices double.
3. The change in the multiple. If investors go from paying 15 times earnings to paying 20, prices rise by a third with no change in the businesses.

The first two come from the companies. The third comes from investors' mood, interest rates, and expectations. Over very long periods it fades in importance, because a multiple can't rise for ever. Over a decade it can be the largest of the three.

Starting at 25 times earnings, with a 1.5% dividend yield and 5% earnings growth	Multiple falls to 18	Multiple stays at 25	Multiple rises to 30
Dividends, per year	1.5%	1.5%	1.5%
Earnings growth, per year	5.0%	5.0%	5.0%
Change in the multiple, per year	−3.2%	0%	+1.8%
Approximate return, per year	3.3%	6.5%	8.3%
$10,000 after ten years	$13,800	$18,800	$22,200

The companies performed identically in all three columns. The only difference is what investors were willing to pay at the end. A high starting multiple leaves more room to fall and less room to rise, which is why the starting point matters.

Measuring the market's price

Several measures are in common use. Each answers a slightly different question.

• The price-to-earnings ratio of an index compares its level with the combined earnings of its companies, either for the past year or as forecast for the next. It's simple, but a recession can crush earnings for a year and make the ratio look alarming just when prices are low. Valuing Cyclical Companies described the same problem for a single company.
• The CAPE ratio, developed by the economist Robert Shiller, deals with that by averaging. It divides the inflation-adjusted level of the S&P 500 by a ten-year average of inflation-adjusted earnings.¹ One strong or weak year barely moves it.
• The earnings yield is the ratio turned upside down: earnings divided by price. A market at 25 times earnings has an earnings yield of 4%. That can be set beside the yield on government bonds, to see how much extra investors are being offered for taking the risk of shares. Earnings Yield and Free Cash Flow Yield introduced the idea for a single company.
• Dividend yield, and market value compared with the size of the economy, are also used. Both are rougher measures. Dividend yield in particular understates what companies return, since many now buy back shares instead.

The rest of this lesson is for members

Still to come in this lesson: What the evidence says, Why the measures are imperfect, How to use it, the key takeaways, and 2 quiz questions with explanations.

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