P1: OTA/XYZP2: ABC c15JWBT347/MckinseyJune 4, 201016:23Printer Name: Hamilton15Market Value Tracks Return on Invested Capital and GrowthOver the past 15 years, investing in the stock market has been a roller-coaster ride. In the second half of the 1990s, the Standard one with a lower ROIC will gain more from im-provingitsROIC.Marketvaluationsreflecttheeffectsofthisrelationship between rates of ROIC and growth on fundamental valuations.Our studies indicate that, in most cases and nearly all of the time, man-agers can safely assume that share prices reflect the markets best estimate of intrinsic value. Therefore managers should continue to make decisions basedon discounted cash flow and economic profit. When the market undergoes a period of irrational behavior, as we explain in Chapter 17, smart managers can detect and perhaps exploit the resulting market deviations. But even decisions taken in moments of market irrationality should be governed by fundamental valuation principles.STOCK MARKETS TRACK ECONOMIC FUNDAMENTALSThebehavioroftheworldskeystockmarketssincethemid-1990shasconfused and frustrated investors and managers. It has led many to question whether the stock market is anything more than a giant roulette table essentially uncon-nected to the real economy shaped by inflation rates, interest rates, growth ingross domestic product (GDP), and corporate profits. However, close scrutiny of real economic activity and stock market movements over time shows that the former does indeed directly explain the latter. In fact, the stock marketsP1: OTA/XYZP2: ABC c15JWBT347/MckinseyJune 4, 201016:23Printer Name: HamiltonSTOCK MARKETS TRACK ECONOMIC FUNDAMENTALS339real surprise lies not in its occasional spectacular price bubbles but, rather, in howcloselythemarkethasmirroredeconomicfundamentalsthroughtwocen- turies of technological revolutions, monetary changes, political and economic crises, and wars. And this is true not just for the U.S. stock market. We believestock markets in Europe and Asia also correctly reflect these regions different underlying economic circumstances and prospects.Explaining Market Returns over Two CenturiesU.S. equities over the past 200 years have on average achieved total returns to shareholdersofabout61/2percentannually,adjustedforinflation.Breathtaking marketbubbles,crashes,orscandalstendtocapturepublicattention,asduringthe financial crisis triggered in 2008, the high-tech market frenzy around the turn ofthe millennium, the Black Monday crash ofOctober1987, the leveraged buyout(LBO)crazeofthe1980s,and,ofcourse,theWallStreetcrashof1929.Butthe effect of any of these relatively short-lived events pales into insignificance against the backdrop of decade after decade of stock returns at a consistent premium over government bonds and bills (Exhibit 15.1). In the long term, as Exhibit 15.1 shows, stock markets are far from chaotic. That 61/2percent long-term real return on common stocks is no random number, either. Its origins lie in the fundamental performance of companiesSource: Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies (New York: McGraw-Hill; 2002); Ibbotson Associates; Morningstar EnCorr SBBI Index Data.$0$10$1$100$1,000$10,000$100,000$1,000,000$10,000,000$100,000,000StocksStocks (Inflation-adjusted)BondsBillsCPI1801 1816 1831 1846 1861 1876 1891 1906 1921 1936 1951 1966 1981 1996 2010EXHIBIT 15.1Stock Performance against Bonds in the Long Run, 18012010P1: OTA/XYZP2: ABC c15JWBT347/MckinseyJune 4, 201016:23Printer Name: Hamilton340MARKET VALUE TRACKS RETURN ON INVESTED CAPITAL AND GROWTHand the returns investors have expected for taking on the risk of investing in them.Onewaytounderstandthislinkageistoexaminetherealeconomysun- derlyingperformanceanditsrelationshiptostocks.Themedianprice-earnings (P/E) ratio in the U.S. stock market tends to hover around a level of about 15 over the long term. Assuming that the typical investors risk preferences are stable, we can easily connect shareholders long-term returns with the fun- damental performance of companies. The P/E for a company with constantgrowth and return on capital is defined as:P/E =1 g ROE k gwhere g = growth, ROE = return on equity, and k = cost of equity. If markets are pricing the companys stock correctly, the expected return on the stock should equal the cost of equity, so that:Expected Return = k =E ?1 g ROE?P+ gWe can interpret this as the sum of the cash flow yield on the stock plus the earnings growth rate.Over the past 70 years, real corporate profits have grown about 3 to 31/2 percent per year. If P/Es revert to a normal level over time, stock prices should therefore also increase about 3 to 31/2percent per year. In addition, corporateAmerica,asawhole,typicallyreinvestsabout50percentofitsprofitseveryyearto achieve this profit growth, leaving the other half to be paid to shareholders as dividends and share repurchases. Fo