GDP, M&A, EBITDA, P/E, NASDAQ, Econo-thread Part 11

[Roland]

My dear Dr rer oec,

"since the original debate was about whether a pick up in growth would affect stock market valuations"

I may have been sloppy in phrasing the long.term trend part, but I really didn't think I would have to make it explicit, as my original quote to which you objected was in reply to this from DanS:

"Rather, the nominal long-term GDP growth rate is assumed to be 6% (3.5% real growth + 2.5% unreal)."

Und unless I've completely misunderstood what he meant, he was making a case for a rate of long-term stock return. No idea you were talking about cyclical effects.

[DrSpike]

Ok then your statement _was_ a long term steady state one (and as I repeatedly said it makes more sense in this case) - but you lead me to believe above this was not the case. Perhaps it is my terminology that is confusing..........if so mea culpa.

In any case in assessing the long term return to stocks (which I think was the root of the debate - yes?) one must consider both the steady state analysis _and_ what will happen on the return to the steady state.

[DrSpike]

Oh and I got the .rer .oec reference btw.

[DanS]

I'm sorta confused where we're at now. The assumption is that over time, GDP growth has everything to do with profit growth, which in turn sets a fair value for equities, profits reinvested. This is because profit as a percentage of GDP fluctuates within a range that is unlikely to change without a major rework of our basic economic system (and social contract, etc.).

Does anybody have major problems with this, if we're talking rule-of-thumb kind of calculations?

[Roland]

"one must consider both the steady state analysis _and_ what will happen on the return to the steady state."

Yes, though the return to the steady state should not have a very dramatic impact at the moment.

"only makes sense at all in a steady state (though not quite as strict an interpretation as zero net investment)"

Well which steady state version are we talking about then ? Flat capital productivity ?

[Roland]

Dan:

"The assumption is that over time, GDP growth has everything to do with profit growth, which in turn sets a fair value for equities, profits reinvested."

My point was that roughly, the output (and therefore the capital share of income from that output) per unit of capital stays the same.

So appreciation of existing stocks comes from retained earnings under the assumption above. And there, earnings growth rates of 4 % mean a 4 % delusion of your share, and growth rates of 6 % a delusion of 6 %.

[DrSpike]

I was just thinking of what you said, a state where the capital stock grows in line with GDP and profit per unit of capital was constant. I have no problem with this as a long run thought experiment - in fact as I said right at the start I applaud that you tried to analyse the problem in this manner.

But as I said this isn't quite correct. The appropriate steady state is one where productivity improvements drive increases in effective capital stock (abstract from depreciation for now), profits and stock prices.

So @ Dan, yeah carry on

[Roland]

"The appropriate steady state is one where productivity improvements drive increases in effective capital stock (abstract from depreciation for now), profits and stock prices."

How do (I assume labour) productivity improvements drive increases in stock prices ?
You need some extra assumptions for that, don't you ?

[DanS]

"So appreciation of existing stocks comes from retained earnings under the assumption above. And there, earnings growth rates of 4 % mean a 4 % delusion of your share, and growth rates of 6 % a delusion of 6 %."

My little mind is having a problem processing this, so please edumacate me if I'm wrong.

This just means that on a portfolio including a proportional share of all productive capital classes, I will be making 6% per annum in perpetuity, rather than a rate above that, right? If so, why would this change the calculation?

[DrSpike]

It is not really a good assumption that all productivity increases enter through labour........TFP is a better concept.

[Roland]

Well TFP or not, capital productivity doesn't change much. Neither does the income share of capital.

[Roland]

Dan:

"I will be making 6% per annum in perpetuity, rather than a rate above that, right?"

Not what I meant.

Let's say all a company's capital is the stocks it issued. You own 1 of 100 shares.

Now it grows output and earnings at 4 %, but to do that it has to expand its capital by 4 % (104 shares). Your EPS stays the same.

Do the same with 6 %. Your EPS stays the same.

Individual companies vary widely from that behaviour, but it's quite close to the overall economy. And in that scenario the only interesting thing is the earnings yield. Be it as dividend or reinvested.

[DrSpike]

Those sorts of statements are misleading at times though........TFP is a much better concept entirely because the notion of marginal products (which are the first order _partial_ derivatives of the production functions), whilst immensely useful to economists, are sometimes tricky to interpret in practice.

[DrSpike]

Either way our differences aren't large here. I suggest you both come over to the capitalism bashing thread and help us educate some people.

[Roland]

I'm always confused about the exact meaning of TFP, MFP or TFP/MFP growth. You mean the statements are misleading because the technology component of TFP growth can change that ?