The Hindu Business Line : Behind the 15% returns

Investment gurus seem to have a ``stock" answer to the question "Where do you expect the markets to go from here?" They often reply: "I don't have a view on the market. But expect a 12-15 per cent return if you hold stocks for a five-year period".

If it is so difficult to say where the markets are headed tomorrow or over the next month, then how can you be confident of that "12-15 per cent return"? The answer to this question actually makes up the foundation to stock market investing.

Stock prices are impacted by several factors; but the most important influence over the long term is the rate of growth in the company's earnings. In simple terms, if a company manages to grow its earnings steadily, its stock price will appreciate and, if earnings tumble, so will the stock price. This is why stock prices are often said to be "slaves" to earnings. Since stock prices tend to track earnings over the long term, forecasting stock price returns is often a matter of determining the rate of growth in a company's earnings over the next few years.

Why, then, do experts predict a 12-15 per cent return on equity investments over a five year period? This return projection is based on the rate of growth expected in the Indian economy. The Indian economy is currently growing at about 8 per cent a year and is expected to sustain this growth rate over a five-year period. This means that the volume of goods and services produced in India will expand by 8 per cent every year. It, therefore, follows that leading Indian companies should also be able to sustain roughly this pace of growth in their output and sales over the next few years. While this captures the growth in volume terms, the selling prices of goods and services (rate of inflation) are rising by about 5 per cent a year. This means that, in rupee terms, companies would be able to grow their sales by about 13 per cent a year (volume growth of 8 per cent plus price increases of 5 per cent). If profits grow at the same rate as sales... . bingo! you arrive at a 13 per cent growth rate in earnings.

Experts like to place a range of 12-15 per cent on their return forecasts as both the economy's growth rate and actual inflation may vary by a few percentage points from the expected levels. The performance of individual companies may also vary substantially from that of the broad economy. But in the past, listed Indian companies have outpaced the broad economy. Earnings of companies which make up the Sensex basket have, for instance, grown by about 22 per cent a year (compounded) over the past five years.

However, you need to remember that stock prices seldom faithfully track earnings from week-to-week or month-to-month. A company's stock price often runs ahead or trails its earnings performance over the short term, given that emotions play such a big role in investing. But holding a stock for a few years gives the market enough time to price in a company's true earnings potential. This is why putting a number to long-term returns from the stock market is much easier than predicting how the Sensex will swing over the next week or two!

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