Calculating g in Grinold-Kroner model , GDP growth real or nominal?

CFA Level III Economics
#1

Hi,

in one of the mock exercice, (Capital Market Expectations O-reilly) one is asked to compute the expected long-term equity return with the following assumptions given:

• The dividend yield will be 1.95%.

• Shares outstanding will decline 1.00%.

• The long-term inflation rate will be 1.75% per year.

• An expansion rate for P/E multiples will be 0.15% per year.

• The long-term corporate earnings growth premium will be 1% above GDP growth.

• GDP growth will be 2.5% per year.

• The risk-free rate will be 2.5%.

The formula is E(Re)≈D/P−ΔS+i+g+ΔPE where

E(Re) = the expected rate of return on equity

D/P = the expected dividend yield

Δ_S_ = the expected percent change in number of shares outstanding

i = the expected inflation rate

g = the expected real total earnings growth rate (not identical to the EPS growth rate in general, with changes in shares outstanding)

Δ_PE_ = the per period percent change in the P/E multiple

I think it is not obvious to find g in this case.

Would you just add GDP growth and the long-term corporate earnings growth premium or deduce inflation from GDP growth?

More generally, does GDP growth figures include or not inflation?

#2

If they give you a GDP growth rate (or any other growth rate, for that matter) with no qualifications, it’s a nominal rate.

If they mean a real rate, they have to specify that it’s a _ real _ rate.

#3

Thanks for your answer ,

This still does not solve the issue for me, since then i would say that the nominal earnings growth rate would be GDP growth + long-term corporate earnings growth premium =3.5%

And consequently real total earnings growth rate = nominal earnings growth rate - inflation = 3.5-1.75=1.75%

(I am relying on the formula nominal = real + inflation )

I do not understand the correction, which states:

According to the Grinold-Kroner model, the expected long-term developed market equity return is equal to the sum of the:

(1) expected income return (dividend yield minus the percentage change in the number of shares outstanding),

(2) expected nominal earnings growth return (long-term inflation rate plus long-term corporate earnings growth rate), and

(3) repricing return (expansion rate for P/E multiples). In this case,

E(Re) = [1.95 - (-1.0)] + [1.75 + 3.50] + 0.15 = 2.95 + 5.25 + 0.15 = 8.35%.

Can you point out where am i wrong?

#4

I think inflation (1.75%) + long-term corporate earnings (2.5% GDP + 1.0% premium) is the right answer. Am I wrong?

#5

So what was the answer on the mock exercise? Did they not make an adjustment to GDP and that’s why you’re asking?

#6

Yes exactly.

I picked the correct answer (8.35) because the other answers proposed did not match my calculation but i do not feel comfortable with the answer

#7

If the GDP measure given is in real terms, inflation must be added. If it is nominal, it would essentially be counting inflation twice.

inflation and g are consolidated into one term but with poor labeling: (2) expected nominal earnings growth return (long-term inflation rate plus long-term corporate earnings growth rate)

Unless it explicitly says real vs. nominal, I would assume you need to add inflation as the formula suggests.