Decomposing a Return Into Earnings, Multiple, and Dividend
Every equity return breaks into three parts: how much profits grew, how much investors changed what they pay for those profits, and what was paid out along the way.
The Three Components
Over any period, an equity return can be attributed to three sources. Earnings growth, meaning the company generated more profit. Multiple change, meaning investors are willing to pay a different number of times those profits. And the dividend yield received during the holding period.
Approximately, total return equals earnings growth plus multiple change plus dividend yield. The approximation is close enough to be genuinely useful and the exercise takes about a minute.
Why the Split Matters
The three components have very different characteristics going forward.
Earnings growth reflects the business doing more, and it can in principle continue indefinitely as long as the company keeps growing. It is the durable component.
Multiple expansion reflects a change in sentiment or in the discount rate. It cannot continue indefinitely, because multiples do not rise forever. A stock that went from 15 times earnings to 30 times cannot repeat that by going to 60. This component is inherently self limiting.
Earnings growth can repeat. Multiple expansion has a ceiling, and returns borrowed from it are returns taken from the future.
Working Through an Example
Consider a stock returning 60 percent over three years. If earnings grew 15 percent annually and the multiple was unchanged, the return came almost entirely from the business, and the same performance is plausible again if growth continues.
If earnings were flat and the multiple went from 12 to 19, the entire return came from investors repricing the same profits. Repeating it requires the multiple reaching 30, which demands increasingly optimistic assumptions.
Both stocks show 60 percent on a screen. They are describing completely different situations, and the screen cannot tell you which you are looking at.
What Drives Multiple Changes
Multiples move for several reasons and it is worth separating them. Interest rates matter mechanically, since a lower discount rate raises the present value of future earnings, which justifies a higher multiple with no change in the business.
Expected growth matters, since a company whose growth outlook improves deserves a higher multiple. Perceived risk matters, since a business seen as more durable warrants a higher multiple for identical current earnings.
And sentiment matters, which is the component that is neither rational nor stable. Distinguishing a rate driven rerating from a sentiment driven one is difficult and it is where most of the analytical value sits.
Applying It to a Period
The exercise is especially clarifying across a full cycle. Much of the equity market's strength during the low rate years came from multiple expansion driven by falling discount rates. When rates rose sharply, that component reversed, which is why 2022 was painful even for companies whose earnings held up.
Periods where returns are supported by earnings growth rather than rerating are structurally more durable, which is why analysts pay close attention to whether an advance is accompanied by actual profit growth.
The Bottom Line
Split any return into earnings growth, multiple change, and dividends before judging it. The first can persist, the second is borrowed from the future, and confusing them is how people extrapolate a rerating into a forecast.