An Interesting Approach Used by McKinsey for Calculating Market Expected Returns: Aggregating Current Stock Prices and Expected Fundamentals
The fundamental formula for value creation can be expressed solely for the equity portion (instead of EV):
- Equity Value = Earnings * (1- g/ROE) / (r[e] – g), =>
- r[e] = Earnings *(1-g/ROE) / Equity Value +g, =>
- r[e] = {1 / (P/E)} * {1-g/ROE} +g
Thus, integrating the P/E ratio.
If we plug in the long-term 14.5% return on equity for the S&P 500 and the 3.5% real GDP growth, we get that the long-term expected real return for the market is 7% (which includes both the risk premium and the risk-free rate). The graph below shows the real and nominal trends constructed based on this approach.
P.S.
A few words about the risk-free rate:
As authors note, in recent years, the long-term risk-free rate has significantly decreased (referring to the period before the Russia-Ukraine war), which theoretically should have led to a decrease in expected returns. However, the market did not react adequately. Therefore, the authors suggest using a synthetic risk-free rate, obtained by summing the current low interest rate and inflation expectations. However, today, interest rates are high, and there are no long-term inflation expectations…
Source:
#VALUATION – Measuring and Managing the Value of Companies
7th Edition
McKinsey & Company
Tim Koller, Marc Goedhart, David Wessels