For over four decades, owners of a diversified pension fund have been used to an annual real return of 5-6%. But it hasn’t always been like that. If you invested one dollar in the post-war years in a diversified portfolio of all publicly traded firms, in 1980 you would still only have had one dollar, or a real return of zero. Instead, if you invested one dollar in 1980, today you would have had nearly 10 dollars, or an average annual return of 5.28%. What changed in 1980? And will it last?
As any investor knows, and paraphrasing Warren Buffett, the intrinsic value is the amount of money that will come out of the business and when. However, well-established research in finance finds no relation between dividends and the pricing of stocks (Cochrane 2011). In other words, the payment to shareholders in the form of dividends does not predict the value of the firm’s stock. The conclusion is therefore that the variation and rise in firm values must be driven by subjective discount factors.
In theory, dividends are the perfect instrument to determine a firm’s value. All profits the firm ever generates in addition to any equity that is held in the firm will eventually be paid out as dividends in the future, possibly at liquidation when the firm ceases to operate. The sum of those dividends suitably discounted is the intrinsic value of the firm. In practice, however, dividends are far from perfect. Only a fraction of profits (on average 45%) is paid out in dividends. Part of the profits are distributed in other forms, such as share buybacks or stock options to employees. And firms retain part of the profits as retained earnings to finance investment instead of recurring to the corporate bonds or bank loans. Firms on average retain 20% of their earnings. Together with the much higher volatility of dividends than profits, the backloading and the other distribution of profits make dividends poor measure of instantaneous and expected future firm profitability.
For that reason, it is appropriate to consider profits to determine the value of the firm, rather than dividends, as I do in a new paper (Eeckhout 2024). After all, analysts often use the price-to-earnings ratio as an indicator of the firm’s value. But there is one caveat that we need to heed here, and not when we use dividends: retained earnings accumulated in the firm. The value of the firm increases as more earnings are retained. So, we need to decompose the contribution to firm value into shareholder equity that is the stock of retained earnings, and the discounted flow of future profits. With dividends that is not necessary because retained earnings are eventually paid out as dividends too.
Figure 1 plots average market value and the different components, normalised to 1 in 1980.
Figure 1 Market value, profits, shareholder equity, and cost of debt (left to right)
To link the future profits to the value of the firm, we need to take a stance on expectations. I use two versions: first, current profits exactly determine future expected profits, growing at the rate of GDP growth; second, I assume that realised profits are equal to expected profits for several periods. Both methods obtain remarkably similar results, indicating the robustness of the approach. I then construct the counterfactual value of the firm, varying one component at a time and keeping all others constant. This is a common method in macroeconomics to measure the contribution of each individual component, namely discounting, expected profits and retained earnings (past profits). Figure 2 plots the contribution of each of these three components.
Figure 2 The counterfactual contribution of each component
I find there is only a minor role for discounting, most of which is due to the fall in the risk-free rate and not the subjective discount factor. Instead, the rise of the stock market valuations is mostly due to the rise of profits. De Loecker et al. (2020) document extensively the rise of market power measured in markups, the ratio of price to cost of production. The data on profits in this paper confirm this trend. The causes behind the rise of profits are the decline in competition, which the literature attributes to technological change, common ownership (Ederer and Pellegrino 2024), data (Eeckhout and Veldkamp 2022). Market power is observed in output markets as well as input markets, such as labour markets (Berger et al. 2023, Di Mauro et al. 2023).
The findings here show that rising profits are closely linked to the value of firms. This is consistent with a growing literature arguing that the distribution of earnings, such as variation in the firm’s labour share, affects the pricing of firms (e.g. Lettau et al. 2015). However, the contribution of profits to the value of the firm consists of two distinct components: the expected future profits and the stock of accumulated past retained earnings. Both account for about the same share in the growth of stock market values. As profits have increased and firms have kept the percentage of profits retained in the firm constant, the stock of retained earnings has grown faster too. The increase in the value of the average firm since the 1980s can thus be decomposed in 20% due to falling interest rates, 40% due to rising profits, and 40% due to a rise in the stock of retained earnings. Rising profits – past, present, and future – are therefore the main contributor to the increase in firm value.
What can we expect for the future? What if profits stop increasing? There is currently an ongoing trend of rising profits, but that may not last. One possible risk to the rising profits is policy risk, in particular competition policy. Profits are good for stockholders and the value of firms, but they generate welfare losses for consumers, startups, and competitors, and negatively affect innovation. Policy risk broadly defined is a major determinant of stock market fluctuations. Baker et al. (2021) document how policy changes lead to a jump in stock market valuations. This is the case for monetary policy changes, but also for any change that affects the profitability of the firm, including competition policy. Of course, market power and the resulting profits are due to an amalgam of factors, including technological change, that may be out of control of competition authorities.
If profits were to drop to the levels we observed in the 1980s, then stock market valuations would drop by 40%. The silver lining is that they don’t fall further, because a policy change does not affect the stock of retained earnings. The counterfactual where profits stay at 1980 levels for every year since would lead to a stock market that is 80% lower today as retained earnings would have grown much less, and the increase would be exclusively due to the falling risk-free interest rate.
All that said, the firms that have market power will keep a close eye on policies that threaten their dominant position (Cowgill et al. 2022). I therefore don’t recommend selling the shares in your pension fund any time soon. I would wait until Lina Kahn from the Federal Trade Commission sells hers.
References
Berger D, K Herkenhoff, A Kostøl, and S Mongey (2023), “The sources of employer market power and avenues for pro-competitive labour market policies,” VoxEU.org, 25 July.
Baker, S, N Bloom, S Davis and M Sammon (2021), “The distinctive character of policy-driven stock market jumps,” VoxEU.org, 21 May.
Cowgill, B, A Prat and T Valletti (2022), “Political power and market power: Evidence from mergers,” VoxEU.org, 16 May.
De Loecker, J, J Eeckhout, and G Unger (2020): “The Rise of Market Power and the Macroeconomic Implications,” Quarterly Journal of Economics 135: 561–644
Di Mauro, F, M Mertens, and B Mottironi (2023), “Sources of large firms’ market power and why it matters,” VoxEU.org, 17 January.
Ederer, F and B Pellegrino (2024), “A Tale of Two Networks: Common Ownership and Product Market Rivalry”, mimeo, Yale University
Eeckhout, J (2024), “The Value and Profits of Firms,” CEPR Discussion Paper 19232.
Eeckhout, J and L Veldkamp (2022), “The role of data in creating market power,” VoxEU.org, 15 August.
Lettau M, S Ludvigson, and D Greenwald (2015), “What moves the stock market?”, VoxEU.org, 30 June.
