Where Stock Returns Really Come From: Payouts, Valuations, and Growth
When investors look to the future, one of the hardest questions to answer is: What kind of returns can we expect from the stock market? In the short run, predicting equity performance is notoriously difficult. Market sentiment shifts quickly, economic data can surprise, and headlines often drive prices in ways that defy logic.
But over longer periods, the fog begins to lift. Equity returns can be broken down into three clear and measurable components: shareholder payouts, valuation changes, and long-term earnings growth. While we can’t forecast next month or even next year with much accuracy, these building blocks provide a framework for setting more realistic expectations about the future.
Three Core Drivers of Return
1. Shareholder Payouts (Dividends + Buybacks)
Companies can return value to shareholders in two main ways:
- Dividends: Cash payments distributed regularly to shareholders.
- Buybacks: Repurchases of company stock, which reduce the number of shares outstanding and increase the ownership stake of remaining shareholders.
Example: A $100 stock that pays a $3 dividend (3% yield) and buys back 2% of its shares in a year provides a combined 5% payout yield to investors.
This three-part breakdown of equity returns—shareholder payouts, valuation changes, and earnings growth—was popularized by John C. Bogle, the founder of Vanguard and a pioneer of index investing. His framework continues to serve as a guide for investors seeking clarity in an otherwise uncertain market.
2. Valuation Change (P/E Ratio Shifts)
Returns are also shaped by how much the current price of the stock.
- If investors become more optimistic and want to buy more of the stock, the stock prices increase.
- If sentiment weakens and investors sell their positions or buyers dry up, the stock price decreases.
These increases and decreases in stock price can happen irrespective of the companies fundamentals (revenue, profits, balance sheet).
To compare this, investors will use the Price to Earnings (P/E) ratio which divides the current price of the stock by the earnings per share.
A low P/E means buyers pay less per $1 of earnings. Lower P/E stocks are considered cheap.
A high P/E means buyers pay more for $1 of earnings. Higher P/E stocks are considered expensive.
Valuation changes are often cyclical and unpredictable, but over the long run, they tend to revert to historical averages.
3. Long-Term Earnings Growth
The most durable engine of equity returns is earnings growth. Over time, company profits expand in line with the growth of the economy—driven by real GDP per capita and inflation.
As earnings rise, companies can increase dividends, fund buybacks, and justify higher stock prices. This compounding effect is why patient investors benefit most from long-term equity exposure.
Historic Return Components
Crestmont Research decomposes the stock market returns using these components covering rolling 10-year returns from 1909 to 2024. The chart below shows the results of that process.
Here are some observations:
- Dividends and Buybacks never produce a negative return which makes sense. A company can’t make you pay them a dividend! However, their share of the total return has been diminishing over the decades. Initially, dividends were a much larger component of total returns than they are today.
- Earnings growth is also very stable over time. With the exception of the decreases during the Great Depression, earnings growth hovers mostly around 5% per year.
- It’s the Valuation Changes that really cause quite a lot of volatility in returns often moving from long periods of valuation increases (stocks getting more expensive) in green followed by periods of valuation decreases (stocks getting cheaper) in red.
Why this Framework Matters
Understanding the three drivers of equity returns isn’t just an academic exercise. It has practical implications both for how investments are managed and for how retirement plans are forecasted.
Investment Management
- Think long term: Earnings growth and shareholder payouts provide the baseline for returns, but they play out over years, not months.
- Avoid market timing: Valuation changes are the least predictable driver and can swing returns sharply in the short run. Trying to trade around these swings often backfires.
- Focus on discipline: A diversified, long-term approach captures the reliable components of return while smoothing out the noise from valuation shifts.
Retirement Planning
- Set realistic return assumptions: Forecasts should be grounded in long-term expectations—not in recent market performance.
- Plan for volatility: Valuation changes introduce uncertainty, especially over 5–10 year horizons. Retirement plans should include buffers, flexibility, or guardrails to handle periods when returns fall short.
- Balance risk and sustainability: Recognizing that some return components are steadier than others helps planners design withdrawal strategies and asset mixes that can withstand downturns while still capturing long-term growth.