If you’re thinking about putting a big chunk of your savings in the S&P 500 for the next decade, you’ll want to have an idea of the range of returns you can expect. Luckily, there’s a framework that can help with that. So let’s take a look at this simple framework and what it tells you about what you might realistically expect…

## What’s the framework?

The important thing to know here is that long-term returns can be broken down into three factors: the growth in earnings per share (EPS), the change in the price-to-earnings (P/E) valuation multiple, and the dividend yield. Mathematically, you can write it as:

**Total S&P 500 return = (EPS growth * P/E multiple growth) + dividend yield**

And, since EPS growth *equals* sales per share growth *multiplied by* margin growth, and sales per share growth *equals* sales growth *divided by* change in the share count, you can break S&P 500 returns down into five components:

**Total return = (Sales growth / share count growth ) * margin growth * P/E multiple growth + dividend yield**

That’s the framework. If you can estimate potential ranges for each variable, then you’ll have a pretty good idea of what returns you can expect over the next ten years. Or, you can flip it on its head, and use the combination of variables that would give you a particular return and decide how likely that does (or doesn’t) seem. But before we look at the future, we must first understand the past.

## What drove returns over the past ten years?

From 2012 until the beginning of this year, the S&P 500 achieved an incredible 16.6% return a year, or *per annum (p/a)*, one of its best runs when calculated over a decade.

Chris Bloomstran, the chief investment officer of Semper Augustus Investments Group, calculated that **an expansion in the P/E multiple, at 6% a year, was the single-largest driver of those returns**, followed by margin growth (3.9%), sales growth (3.5%), the dividend yield (2.4%), and a decrease in the share count due to buybacks (0.7%). **Taken together, the expansion in margins and valuations generated an impressive 10% return per year**.

*S&P500 return attribution: 2011-2021. Source: Chris Bloomstran*

## What’s happened this year?

We’ve had a reality check. At the beginning of January this year, forward-looking ten-year returns were looking particularly bleak: since margins and valuations were at record highs, they were unlikely to drive as much return as they used to. That left sales growth, buybacks, and dividend as the main drivers. But even if you were optimistic and expected sales growth of 4%, buybacks of 1% and a dividend yield of 2% – all higher than history – the expected return at that point wouldn’t have gone much higher than 7% per annum, less than half its average for the past decade.

Then 2022 began to unfold. And when the Fed started to hike rates in earnest to fight soaring inflation, the P/E multiple shrank by 25% and margins by 8%. But companies largely managed to pass on those higher costs to customers, boosting sales by 9% over that period, enough to offset the lower margins. Meanwhile, the share count decreased by 0.8%, and the dividend yield increased to 1.9%. Put differently, **this year’s market decline has been fully driven by a contraction in valuations, and not by deteriorating fundamentals**.

*S&P500 return attribution: 2022. Source: Chris Bloomstran*

**What returns can you expect for the next ten years?**

### Very optimistic: 10% per year.

If you keep the dividend yield, buyback rate, and sales growth constant, you’d need to see both margins and P/E multiples go back to their previous highs to get an annualized return of 10%. Alternatively, if you assume that P/E multiples and margins remain at today’s (elevated) levels, then you’d need to see sales growth more than double and buyback or dividend rates go significantly higher to reach 10%. While this is possible, it’s arguably *very* optimistic as it would require the macroeconomic environment to be as supportive as it was over the past decade. Even then, the annual average return would be far lower than the 16.6% we saw over that period.

### Optimistic: 6%-7% per year.

If you assume margins and P/E multiples will remain at their current high level, and expect sales and buybacks to grow at their historical rates, then you can anticipate making about 6% in returns per year over the next decade. Now, it might sound pessimistic, rather than optimistic, to expect zero margin and valuation growth. But it’s actually not. First, those two measures have historically been mean-reverting – in other words, they may stray from their usual levels but they eventually snap back to them. And they’re both currently near the top of their ranges (particularly margins). Second, the factors that pushed them to new highs (e.g. tax cuts, falling interest rates, stable growth and inflation, and easy access to debt) are likely to be challenged over the coming decade. And, sure, inflation would boost the value of sales in dollar terms. But it would also likely drive a more-than-proportionate decline in both margins and valuation multiples.

*Assumptions to get to 6% return per year. Source: Finimize.*

### Base case: 4%-5% per year.

If you assume that a less-stable economic backdrop would bring multiples and margins closer to their recent averages (but still higher), then you’re looking at making just 4%-5% per year. This isn’t a pessimistic forecast: it assumes sales per share will grow at 4.8%, EPS at 3.8%, and the dividend yield will remain at 1.7%.

This rate of return is already much higher than the negative return you’d have expected at the beginning of the year using the same assumptions (which, by the way, highlights how much timing can add to your long-term returns – if you get it right), but it’s arguably much lower than what most investors expect.

*Assumptions to get to 4% return per year. Source: Finimize.*

### Pessimistic: 0-3% per year.

Thanks to this year’s contraction in valuations and margins, it’s a lot less likely we end the decade with zero returns. But it’s not impossible. If the world is indeed entering into a more challenging period of higher inflation, higher interest rates, higher geopolitical risk, and higher government intervention, plus deleveraging and deglobalization, as many people expect, then margins and multiples could fall closer to their longer-term averages. If that happened, you could still get earnings growth of almost 2%, but your annualized returns would drop to below 3%. If sales or buyback growth slowed too, you’d make even less.

*Assumptions to get to 0%-1% return per year. Source: Finimize.*

## So what’s the opportunity?

This year’s drop in the P/E multiple has made stocks a lot more attractive than they were at the beginning of the year. But with margins at the top of their range and valuations still above their long-term average, buying and holding the S&P 500 is unlikely to give you the attractive double-digit returns it did in the past ten years.

To generate higher returns, you might have to take more risks, either by identifying stocks that will benefit from a better combination of sales growth, margin expansion, and cheaper valuations, or by timing your entries and exits. Smaller size, value companies in the US, or stocks in emerging markets or in Europe might provide a good hunting ground for those.

No matter what approach you take, using this framework could be valuable to you: by stress-testing your assumptions and gaining a better understanding of the fundamental drivers of stock returns, you’ll be in a good place to form a more informed forecast –one that takes you well beyond the old finger-in-the-air approach.