One number, three sources
A long-run equity return can be decomposed, to a very good approximation, into three additive parts: the income the business paid you, the growth in the earnings behind the share, and the change in what the market was willing to pay for each unit of those earnings.
That is not a model with assumptions in it. It is close to an identity — it follows from the definition of a price-to-earnings multiple. And it is the single most clarifying lens available for looking at any historical return, your own included.
Yield
Cash the business handed you
Repeatable, and independent of sentiment
Growth
Expansion in the underlying earnings
Repeatable, and the only source that creates rather than transfers
Re-rating
Change in what the market pays per unit of earnings
One-time, mean-reverting, and borrowed from the future
The first two are wages. The third is a loan from the next decade, and it does not announce itself as one.
Why the third one is different
Earnings growth and dividends are produced by a business doing business. They can, in principle, continue indefinitely. Multiple expansion cannot, and the reason is structural rather than empirical.
If a market re-rates from 15× earnings to 25×, that is a substantial contribution to a decade's return. But the multiple cannot repeat the trick without going to 42×, and then 70×. At some point the re-rating stops, and when it does, the return available from that point forward is only yield plus growth — from a starting multiple that is now much higher, and therefore with much more downside if the multiple ever normalises.
| Source of return | Portfolio A | Portfolio B |
|---|---|---|
| Dividend yield | 1.5% p.a. | 1.5% p.a. |
| Earnings growth | 11.0% p.a. | 4.0% p.a. |
| Multiple change | 0.0% p.a. | 7.0% p.a. |
| Total return | 12.5% p.a. | 12.5% p.a. |
| Ending multiple | Unchanged | Roughly doubled |
| What the next decade needs | The business to keep growing | The business to keep growing and the multiple to stay where it is |
Illustrative arithmetic to show the structure of the decomposition. Not a forecast, not a description of any actual market or portfolio, and not a recommendation.
Portfolio B is not a worse portfolio and its investor did not do anything wrong. But its investor has been paid, in part, by a change in other people's willingness to pay — and is now carrying an exposure to that willingness reversing. The performance table shows two identical numbers. The risk positions are not remotely identical.
The expectations embedded in a price
The decomposition has a forward-looking twin that is even more useful. Any price can be read backwards to recover what it is assuming.
If a company trades at a high multiple, the market is not saying the company is good. It is saying the company will grow at a rate that justifies the multiple. Those are different claims, and the second is a far higher bar. A genuinely excellent business at a price that assumes more than excellence is a poor investment; a mediocre business at a price assuming decline is frequently a good one.
- 1
Ask what growth rate the price implies
Not whether the growth is achievable — whether it is already paid for. The relevant question is never 'will this company do well' but 'will it do better than the price already assumes'.
- 2
Ask how long the implied growth must persist
High multiples embed not just a rate but a duration. A demanding rate for three years is a different bet from the same rate for fifteen, and the second is far rarer than prices generally imply.
- 3
Ask what happens if the multiple simply normalises
Hold growth constant and let the multiple return to its own long-run level. If the resulting return is poor, then the investment case is a bet on sentiment rather than on the business, whatever the narrative says.
- 4
Ask what the accounts would have to show to break it
The decomposition makes this concrete: a specific earnings trajectory, over a specific period, observable in a specific filing. That is a falsifiable thesis, which is more than most investment cases offer.
How to use it on your own portfolio
The decomposition is not only an analytical tool for individual securities. It is the most useful thing you can do to your own track record, and it requires almost no work.
Take the period over which you have been invested. Find the aggregate earnings of what you hold at the start and at the end, and the multiple at the start and at the end. Three numbers fall out: how much of your return came from income, how much from businesses earning more, and how much from the market changing its mind about what those earnings are worth.
The purpose of the exercise is not self-criticism. It is calibration. An investor who knows that two-thirds of their last decade came from re-rating will set a very different expectation for the next one — and setting the right expectation is most of what prevents the sequence of bad decisions that a disappointed expectation produces.
Returns come from businesses earning money, from businesses distributing money, and from other people changing their minds. Two of those compound. One of them is borrowed. It costs nothing to know which one paid you.
Important information
This article is general information and investment education. It is not investment advice, a research recommendation, or an offer or solicitation to buy or sell any security, fund or instrument, and it does not take account of the objectives, financial situation or particular needs of any individual reader. Illustrative figures are used to explain a concept and are not forecasts or performance records. Investments are subject to market risk, including the possible loss of capital. Consider your own circumstances, and where appropriate take professional advice, before acting on anything you read here.