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It has been many years since I completed my MBA program, but I remember the statistics professor constantly reminding us to "let the data lead you." By this he meant that, once you have accumulated a database of observations, don't start mining it for statistics that support your predetermined conclusion. Instead, approach the data with an open mind and maybe they will lead you to a conclusion you never suspected.

In his view, too many people tortured the information until it confessed to crimes it never committed. This sounds like much of the investment research produced today. Analysts forecast earnings a few years down the road, apply a price-to-earnings (P/E) ratio to reflect the exponential growth anticipated, then multiply the two figures to arrive at the target price for a stock.

As an alternative approach, why not take the numbers already embedded in today's market price and work backward to extract the growth rate and expected return implied by these statistics? We may not know the right answer when we see it, but some answers will be so irrational that only a delusional investor would pay the current price. In other words, let the market data lead us.

According to the textbooks, the price of a common stock is the present value of a growing stream of dividends, discounted at the investor's expected rate of return. For the mathematically inclined, the valuation equation is: Price equals dividend divided by (k minus g), where k is the investor's expected return and g is the forecast growth rate of the dividends. In applying it to individual stocks, the model has two limitations: Many companies do not pay dividends and likely never will, and many analysts and investors have the bizarre expectation that the potential growth of a company far exceeds their required return. In this case, they can pay an infinite amount for such an investment. If this sounds preposterous, think back 15 years: Internet stocks with no earnings traded at extravagant multiples of forecast revenues.

The valuation model has more practical value when we apply it to a market index that has stability in the various components and modify it by dividing both sides by earnings. In this case, the left side converts to the familiar P/E ratio while the right side (dividend divided by earnings) becomes the dividend payout ratio, divided by (k minus g).

Turning to the S&P/TSX composite index, the current P/E ratio is about 14 and the dividend payout ratio is approximately 50 per cent. With two out of three inputs identified, it is a simple step to calculate that the spread between k and g must be 3.6 per cent. (According to our formula, 14 P/E equals the 50-per-cent dividend payout divided by the 3.6-per-cent spread.)

Now that we know the spread between k and g, we can explore states of the world that make sense to a rational investor. For example, right now most Canadians would be happy to see the economy growing in the 2-per-cent to 3-per-cent range. Maybe TSX-listed companies can grow earnings (and dividends) a little faster, but even if they grow at 4 per cent, at 14 times earnings Canadian equities are priced to deliver barely an 8-per-cent rate of return (4.0 plus 3.6). If inflation remains at 2 per cent or below, this would be in line with long-term historical experience, but I suspect that many equity investors and pension plans have more ambitious targets.

If your return expectation from equities is in the low double digits (10 per cent to 12 per cent), then with a 3.6-per-cent spread you must be hoping for a dramatic recovery in the global economy to something approaching 8-per-cent growth. Or be confident in your ability to identify companies trading at a market multiple but capable of sustaining growth rates in the 6-per-cent to 8-per-cent range. Financial markets are efficient mainly because a large number of investors believe they can beat the average, so we should encourage this belief. The rest of us can expect a return from Canadian equities in the region of 8 per cent.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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