John Bogle’s Estimated Future Annual Total Return Formula

John Bogle’s Annual Total Return Of A Stock

 John Bogle, the founder of Vanguard and arguably the father of index fund investing used a simple formula to calculate estimated future annual total return, as described in his book, Don’t Count On It. Bogle also discusses future annual returns in his book Common Sense on Mutual Funds. Since I have a copy of this book on my desk I will draw upon it now to describe John Bogle’s future annual total return formula.

Bogle advances a simple concept that three variables determine the total stock market returns over the long term:

• The dividend yield at the time of initial investment
• The subsequent rate of growth in earnings
• The change in price-earnings ratio during the period of investment

In his book, Bogle goes on to state that

The total of these three components explain nearly all of the stock market’s returns over extended holding periods. By analyzing the contributions to total return of the three factors, reasoned consideration of future returns can take place. The initial dividend yield is a known quantity. the rate of earnings growth has usually been relatively predictable within fairly narrow parameters. And the change in the price-earnings has proven highly speculative. Total return is simply the sum of these three factors.

John Bogle’s Total Return Forumula

He first presented his insight and total return formula in the 1991 paper entitled, “Investing in the 1990s” in The Journal of Portfolio Management. He revisits the formula in a 2015 paper entitled, “Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns” in the The Journal of Portfolio Management. Basically, the future annual total return of an asset is the income it generates plus the change in price. John Bogle’s total return formula is expressed as:

For stocks, income is represented by the dividend, or”

For stocks the ‘Change in Price’ can be further sub-divided into two components that are Earnings Growth and Annualized Change in price-to-earnings ratio (P/E ratio). This is expressed as:

This three variable formula is simple and almost any small investor can make use of it. First, let’s now briefly examine each component of the formula.

Dividend Yield

Dividends are the amount of cash distributions that companies pay out on periodic basis from earnings to shareholders. This amount is in excess of the capital expenditures needed for investing in and growing the business. The dollar amount of the dividend divided by the stock price determines the dividend yield. Hence, market action can affect the dividend yield and it can be a measure of valuation when compared to historical yields or market averages.

Dividend yields can be a significant source of total return for companies in some industries, e.g. utilities, consumer staples, and financials. Note that distressed companies can often have high dividend yields due to large declines in the stock price.

Future Earnings Growth

Earnings growth is the amount that a company’s or stock’s earnings per share is expected to grow over time. In general, companies aim to grow their top line (revenue) and bottom line (earnings per share) over time. The value used here is the expected or future earnings growth. Past earnings growth is based on real data.

On the other hand, expected earnings growth is an estimate. This is often difficult to determine. But it can be based on past earnings per share growth rates extrapolated forward, the company’s guidance, or averages of analyst estimates. One difficulty is that earnings growth estimates may become unreliable for longer future periods of time due to the ups and downs of the business cycle, unpredictable company specific issues, and so-called ‘Black Swan’ events, e.g. COVID-19 pandemic.

Because this variable is derived on a per share basis, other factors, like share buybacks or issuances can influence the growth rate. Share buybacks add to growth, while issuances subtract from growth.

Change In Price-to-Earnings or P/E Ratio

The P/E ratio is commonly used as a metric for valuation. Change in price-to-earnings or P/E ratio is simply the expected increase or decrease in the P/E ratio for a stock.

The P/E ratio is the stock price divided by EPS. If the current EPS is used then the metric is P/E (TTM), where TTM = trailing twelve months. If the EPS is based on company guidance or analyst estimates, i.e. estimated EPS, then the metric is P/E (FWD), where FWD = forward.

The P/E ratio will also change with time as the company’s stock price fluctuates due to market action and EPS increases or decrease. An undervalued stock, trading below its historical P/E ratio will have a tailwind from expansion of the metric. An overvalued stock, trading above its historical valuation will have a headwind from contraction of the metric.

Does John Bogle’s Total Return Formula Work?

The aforesaid Total Return formula works reasonably well but it is not perfect as seen in the chart below. The chart shows the sources of S&P 500 Index returns and the actual annual returns. By each decade, the aforementioned formula gives a pretty good estimate of the actual annual total return.

But one caveat is that the earnings growth estimate needs to be based on sound assumptions. A second caveat is that the long-term valuation multiple needs to be reasonably accurate. If not, then the formula will result in too high or too low estimates of future annual total returns.

A few things stand out in the above chart from Bogle’s book. First, the dividend yield is much lower since about the year 2000 than before the year 2000. This may partly be due to the rise of tech stocks that often pay only small dividends or in may cases no dividends.

In addition, many companies now emphasize stock buybacks in addition to dividends. This was arguably not the case before 2000. For some companies future earnings growth is fairly predictable. For instance, utilities, consumer staples companies, REITs, and a few others tend to have stable growth rates. Other companies, however, have much more volatile growth rates dependent on the business cycle.

Differences between Jack Bogle’s formula and actual annual returns are because of simplifications. For instance, share repurchases, foreign exchange conversions, and poor estimates can cause differences.

Final Thoughts on John Bogle’s Total Return Forumula

The formula is fairly simple to use and can easily be done by hand or in a spreadsheet. It provides a quick and easy way to check if a stock investment has a decent future total return. The formula does not forecast the future but it does provide a methodical and systematic way to estimate expected future returns of a stock investment or the broader market. In turn, investors can compare stocks based on total future returns.

As John Bogle said,

 “Investing is not nearly as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.”

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