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    Estimating rates of return

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    If the P/E ratio on the S&P 500 is 10, given historical earnings growth patterns, what would be a reasonable estimate of long-run future expected rates of return on the stock market? Assume a long-run inflation rate of 2.5% per annum.

    Note: Please explain question in detail so I can better understand.

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    Solution Preview

    Here is a simple definition of the P/E ratio:

    The price-to-earnings ratio, or P-E ratio, or P/E ratio, is an equity valuation multiple. It is defined as market price per share divided by annual earnings per share.

    In the case above, this multiple is 10; that is, for every dollar of earnings per share, the stock has a value of 10 cents. Now, assuming this ratio remains the same, then it is logical to conclude that the value of the stock will increase IN PROPORTION to the increase in earnings by a multiple of 10, ADJUSTED for the inflation rate of 2.5% (inflation represents the amount by which prices increase versus the ability to consume --- meaning that if prices increase by 2.5% inflated, then consumption ability has generally decreased by that ...

    Solution Summary

    A discussion of real versus expected investment returns based upon historical growth patterns of the stock market.