John Bogle, founder of the Vanguard group, has a "formula" for calculating future expectations of index returns. Although an index investor is just looking to capture the market return, that return should beat risk free investments and this formula helps in asset allocation.
Bogle adds up (historic) dividend yield + earnings growth +/- change in PE ratio. Say, dividend yield for an index is one per cent; the EPS growth for the last year is five per cent. Also say, the index PE has moved from PE 15 a year ago, to PE 20, that is a change of plus 5. (These numbers are random). The Bogle formula gives future expectations of (2 + 5 + 5) or 12 per cent. Bogle uses longer term data. He says, over the decades, the formula has been fairly accurate for the US markets (available data goes back to 1900).
If you applied this formula to Indian markets now, the Nifty has a PE of 23. The Nifty was at around PE 18 in October 2011. So, it is up by about PE 5 in the past five years. The dividend yield has usually been in the range of 1.3-1.5 per cent. A conservative estimate takes the yield as 1.3 per cent. The Nifty's EPS has grown from Rs 280 in October 2011, to Rs 370 now. That's a five year CAGR of 5.8 per cent.
Using the Bogle formula, the expectations for future returns would be (1.5 + 5 + 5.8) which is about 12.3 per cent. The Nifty moved from about 4,850 in October 2011, to about 8,520 now. That's a CAGR of 11.9 per cent on price, and if we add back the dividend, it is 13.2 per cent total returns. So, the formula gives a reasonable approximation of past return. (A difference of even one per cent will compound into very big long-term differences).
What is the underlying logic? This formula assumes future growth will trend close to historical growth rates, and it allows for valuation rerating. First, dividend is money in hand. Second, by definition, EPS into PE gives us share price. If EPS grows at historical trend, and PE valuations grow as well, capital gains will arise.
If valuation drops going forward, or if earnings growth drops, returns will drop. Current Nifty earnings expectations for Q2, 2016-17 is three per cent. The three year CAGR for Nifty EPS is two per cent. The median ten-year PE for the Nifty is 19.2. If valuations drop back to median, that would mean subtracting 4 from expectations. If you add up 1.3+3 and then subtract 4, the expectations drop to 0.3 per cent. If there's a correction and valuations fall even more, returns could go negative.
It is possible that valuations may gain but this is unlikely since PE 23 has rarely sustained for any length of time. But for what it's worth, valuation improved a lot after liberalisation. In the 1985-1991 period, the Sensex (which was then the major index) had single-digit and low double-digit PEs, of between 9-12, according to studies by L C Gupta. After liberalisation, PE valuations rose, as did earnings growth rates. Despite several big bear markets, the index has returned a CAGR of 11.3 per cent through 1991-2016 (neglecting dividend yield).
Remember the old statement about past performance not being an indicator of future results? The Bogle formula has been reasonably accurate and this makes it an useful rule of thumb for asset allocation decisions. But, it could also go wrong for a given period. As of now, dividend yield should remain stable and EPS growth could rise. But, valuations are likely to fall.