Aaron McDaid

'Capital growth prospects' are very often misunderstood. It is often interpreted as 'house prices rocket forever' and drivel such as 'Microsoft will return to its traditional, very large, price earnings ratio'.

The price of an asset cannot be any more or any less that the sum total of all future income. And future incomes aren't as valuable as immediate consumption; you're not going to pay a full year's rent in 2009 to be able to use a house during the year 2020. So a house is only ever going to be worth approximately 20 years' rent.

In the 1980s it did make sense for Microsoft to trade at much higher P/E ratio. This was because people, quite reasonably, thought that future earnings at Microsoft would be much higher than current ones as the whole software industry grew. As time went by, and the higher incomes were realized, traders would keep looking into the future and see continually rising revenues and would continue to trade at higher than market-average P/E ratios.

Therefore, there isn't really such a thing as a 'growth' stock in the sense of prices magically increasing to give capital gains. The only 'growth' is income growth. The market may well disagree on what the future income will be, but they shouldn't factor in other magical quantities.

Microsoft's P/E ratio is dropping. This is not a sign of bad management or a crisis in confidence in Microsoft. It's simply an acknowledgement that Microsoft has fulfilled its promise and is approximately as big as it could ever be. Unless you believe that Microsoft's revenues could someday be greater than the world's GDP, then their PE ratio will inevitably drop to boring values (15 to 30, for example) until Microsoft is replaced.

So you can't really justify house prices being 100 years' rent, as happened in parts of many cities over the years up to 2008, without believing that future rents would be five to 10 times as high as current rents. This theory expects that you believe that within decades we'd be paying more in rent than we are taking home as income!