What Equity Returns Really Are
When people talk about ‘equity returns’, they often mean whatever percentage number the market happened to deliver over the last year. That is useful for storytelling, but it is not a definition. A cleaner way to think about equity returns is to break them into the handful of components that mechanically have to add up to the total.
A helpful starting point is the distinction between price return and total return. Price return is simply the change in the market price of the shares. Total return is what an investor actually earns once cashflows are included, typically assuming distributions are reinvested. In other words:
Total return = price return + income and other shareholder distributions (reinvested)
This difference matters because you can have a strong price return with weak total return if a market delivers little in the way of distributions, and you can also have a modest price return but decent total return if distributions do much of the heavy lifting. When people cite historical equity performance, they are usually referring to total return indices for exactly this reason: they reflect the full investor experience, not just the change in the quote on a screen.
From there, equity returns can be decomposed into three moving parts. First is what shareholders receive directly in cash terms, or cash-like terms, through distributions. Second is how much the underlying earnings base grows over time. Third is how much investors are willing to pay for a given pound of those earnings, which is simply the change in the valuation multiple. Written plainly, the idea is:
Expected nominal equity return ≈ shareholder yield + nominal earnings growth + change in valuation multiple
The first term is where a lot of confusion creeps in, because many people use ‘dividend yield’ as a synonym for ‘yield’. In reality, dividends are only one way of handing cash back to shareholders. The broader measure is shareholder yield:
Shareholder yield = dividend yield + net buyback yield
Net buybacks matter because they reduce the share count, increasing each remaining shareholder’s claim on future earnings and cashflows. In markets where buybacks are common, focusing on dividends alone can understate the cash being returned to shareholders. More broadly, ‘cash returned to shareholders’ should be understood as a capital allocation decision rather than a single line item. Cash can reach shareholders through dividends, through share buybacks (so long as shares are repurchased at intrinsic value or less), and indirectly through the retirement of debt, which reduces risk and frees up future cashflows that would otherwise have gone to creditors. The flip side is reinvestment: retained earnings can be deployed into future growth, but only if that growth is expected to earn an attractive return on invested capital. If management can reinvest at a high ROIC, shareholders may rationally prefer reinvestment to an immediate cash dividend, because compounding inside the business at a strong rate is itself a form of value creation.
The second term, nominal earnings growth, is the fundamental engine of long-run equity returns. Companies that grow their earnings can pay higher dividends in the future, buy back more shares, reinvest more profitably, or simply become more valuable claims on a larger stream of cashflows. Over multi-decade horizons, this component tends to be tied to real economic growth plus inflation, with some added nuance from changes in profit margins and the share of national income accruing to capital.
The third term, the change in the valuation multiple, is the awkward one. It is real, it is powerful over short and medium horizons, and it is also the least reliable to ‘count on’ going forward. Importantly, this is the piece that tends to dominate price returns over shorter horizons. If the market starts at a high multiple and ends at a lower one, realised price returns can be weak even if earnings grow nicely. If the price multiple rerates upwards, price returns can look spectacular even if business fundamentals don’t markedly improve. Total return can still be cushioned by distributions, but when valuation multiples move sharply, they tend to swamp everything else in the short run.
This decomposition is not a forecasting trick. It is a way to keep expectations honest. If you believe future equity returns will be high, you are implicitly arguing that at least one of these components will be unusually strong: shareholder yield will be high, earnings growth will be high, valuation multiples will rise, or some combination of the three. If you argue that future returns will be low, you are implicitly making the opposite claim. Either way, the framework forces clarity. It makes it harder to hide behind a single headline number, and easier to see what has to be true for a return assumption to make sense.
Practically, this is also a useful reminder for investors: most of what drives long-term equity outcomes is boring. That is because shareholder yield and nominal earnings growth are slow-moving. Valuation changes, on the other hand, are volatile and emotionally gripping, but they are also the part least under an investor’s control. A sensible process for evaluating expected returns in equities acknowledges all three components, uses conservative assumptions for the multiple term, and focuses attention on the things that can actually be implemented. For example, diversification, managing costs, enforcing rebalancing discipline, and determining an asset allocation that matches the investor’s time horizon and tolerance for drawdowns.