It’s commonly quoted that “stocks make 10% per year”. Here’s why they will not continue to do so. Let’s start at the beginning.

Irving Fisher was an economics professor, presidential advisor, and financial commentator in the early 20th century, and his contributions to economic theory are unparalleled. He pioneered the “dividend discount model” (DDM), and, in general, was a brilliant man who belongs on Mt. Rushmore between George Washington and Mr. T.

The DDM holds that “any stock is ultimately worth no more than what it will provide investors in current and future dividends”.

Here, P₀ is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected dividend growth rate. Don’t be put off by the fancy equation, even South Carolina’s Miss Teen USA could understand it.

Well, maybe not.

If a stock pays a $1 dividend that will grow at 3% per year, and we require a 10% rate-of-return, the stock can be valued at $1 / (0.10 – 0.03), or about $14.30.

The real beauty is we can re-arrange this equation to what’s known as the “Gordon Equation”Named after, I’ll assume, NASCAR driver Jeff Gordon: Expected market return = dividend growth plus dividend yield. This is a stunningly simple yet powerful tool. During the 20th century, the average dividend yield was 4.5%, and compounded rate of dividend growth was also about 4.5%. This predicts an average market return of 9.0% per year, while the actual return was 9.89%. The difference comes from the fact that stocks became more expensive during this period – the dividend yield had fallen.

Now let’s use this formula to predict the future. The S&P 500 currently yields 1.68%. Long-term dividend growth rates are relatively stable, and there’s no reason to expect them to exceed the historical 4.5% rate I mentioned earlier.

Add these numbers together, and we get an expected long-term return of 6.2% per year. Ouch. Even using a very optimistic 6% dividend growth rate just gets us up to a 7.7% return. Note that this says nothing of day-to-day or even year-to-year returns, only over the very long term, and this not a perfect model. It is, however, absolutely something to be aware of as you plan your retirement.

These numbers are a bit disheartening. I feel dirty, as if I just kicked a baby poodle or ate at Taco Bell. So, to cheer us up, here’s a picture of Wilt Chamberlain and Andre the Giant holding up Arnold Schwarzenegger.