This Is Where Stock Returns Come From

Jake - Author/Founder

Jake - Author/Founder

I'm Jake. I believe you can build a wealthy life through frugal living and index investing.

It is hard to remain calm and collected when the market is swinging wildly.

To reduce this discomfort, I’ve always found it helpful to fall back on the foundations of where stock returns come from.

Stock returns are rooted in earnings produced by the businesses that you own. In the case of index funds, you share in the total earnings generated by a collection of businesses.

In this post, I will share what I’ve learned about where stock returns come from. You may also learn a thing or two about pie.

I hope this post helps you remain invested so that you can access the long-run compounded returns of the market 🙂

The Source Of Long Run Stock Returns

The price of any investment is based on present and future expected cash flows.

For stocks, those cash flows come from earnings that the business generates.

These earnings can be shared with you via dividends or via share buybacks. 

Of course, the price you pay for these earnings also matters. A lower price often increases the dividend yield (cash flow), or increases the return from share buybacks.  

Long Term Returns = Earnings Growth (per share) + Dividend Yield.

Another way to look at long-run stock returns is through the price you pay for earnings, where the total expected return is reflected by the earnings yield: 

 

Long Term Returns = (Earnings Per Share)/(Price Per Share) = Earnings Yield. 

Infographic: Cashflow Sources

As prices and current earnings swing wildly, the future earnings power of the business often remains unchanged. Further, dividends paid to businesses have more stability than prices (and earnings).

Faith in the fundamentals of the business, or group of businesses, will help you remain invested.

Let’s explore these ideas in more detail, starting with the most fundamental principle – the definition of a stock.

What is a Stock?

A stock represents partial ownership of a business. It is easy to lose sight of this. 

It’s helpful to think of a business like a pie, where each piece of the pie represents a “share” of the business.

The number of slices represents the number of “shares outstanding”.  When the number of shares outstanding increases, each “share” will represent a smaller portion of the business. 

As a business grows, so does the pie, and each piece of the pie also increases in size. This equates to an increase in share price.

As a stockholder (and business owner) you get to share in the earnings that the business generates.

These earnings can increase the value of each share, or they can be paid out in a cash payment (a dividend).

Let’s look deeper into the ways that a business shares earnings with you. 

What Are Earnings?

Earnings represent the money left over after a business pays off expenses and income taxes. This is best shown through example.

Consider this super exciting soap business that sells $10,000 of soap this month. 

After expenses, the business has $4,500 left. This is the month’s net income. 

Finally, the business pays taxes at a 25% rate. Now the business is left with $3,375 of monthly earnings.  

Earnings Breakdown Example

Now you know that stock returns come from earnings. And you know what earnings are.

It’s time to see how earnings are actually shared with you. 

How Are Earnings Shared with You?

When you own 10% of a business, you access 10% of the present (and future) earnings.

That is clear.

But the mechanisms by which a business shares these earnings with you are less clear.

There are two main ways a business can use its earnings:

  • Earnings can be retained; and/or
  • Earnings can be paid out in the form of cash dividends.

Retained Earnings

Earnings that are retained in the business can be used for a few different things: 

  • To purchase assets. 
  • Pay down debt. 
  • Increase cash reserves. 
  • Buyback shares.

Retained earnings increase the value of a company. When the value of the business increases, so does the value of each share of that business.

The business is the pie, remember?

The pie just got bigger, and your specific slice of the pie also got larger. Retained earnings show up in your pocket in the form of an increase in share price. This is called a capital gain. 

Dividends

Businesses that are no longer growing like weeds will distribute most of their earnings in the form of cash payments called dividends.

This means the company doesn’t have good ways to re-invest the earnings back in the business. 

These cash payments are normally made quarterly – every 4 months. 

The fraction of earnings paid out as a dividend is called the “payout ratio”. It is often between 30% and 70%. 

As earnings grow, so do dividends! Say a business pays out 50% of its earnings via dividends, and earnings grow by 10%. It will increase the dividend by 10% as well. 

As dividends are paid, it reduces earnings retained in the business. This in turn reduces the rate of share price growth. So either you see the earnings in the form of a dividend, or an increase in share price. 

Some companies have a payout ratio of over 100%. Clearly, that’s a problem. 

The business doesn’t generate enough earnings to sustain the dividend. It must cannibalize itself to keep up with dividend payments.

Eventually, the dividend will need to be cut.

S&P500 Earnings and Dividend Growth

Share Buybacks

Share buybacks are another way that a business can return earnings to owners (shareholders). I like share buybacks – they are interesting. 

A share buyback is when a business uses retained earnings to “buy back” its own shares. This reduces the total number of shares outstanding, as the purchased shares are absorbed into the business. 

This brings us back to the pie. 

Share buybacks reduce the number of slices in the pie, but the pie doesn’t change in size. As the number of slices in the pie decreases, the size of each slice increases.

Example time. Assume a company has 10 outstanding shares and uses it’s retained earnings (and cash) to buy back 5 of its own shares. Now there are only 5 shares outstanding. 

Now the company value is split over 1/2 the number of shares, and so are the earnings. The value of each share now doubles, and so does the earnings per share. 

Pie Chart

There are fewer shares, but the company remains the same. The earnings per share (EPS) go up as earnings are distributed over a smaller number of shares. 

Remember the fancy formula above? EPS growth is a key factor in long-term stock returns.  

After share buybacks, you can expect to see a higher dividend yield, a higher EPS, and a higher stock price (a capital gain).   

Dividend's Don't Matter

After discussing retained earnings, share buybacks, and dividends we can come to one conclusion. 

Dividends don’t matter. Only earnings matter. 

A company can use share buybacks to return money to shareholders, having the exact same effect as paying cash dividends. 

A company that uses share buybacks will prop up the earnings growth rate to cover the amount that would otherwise have been paid out as a cash dividend. 

In fact, share buybacks are more tax-efficient for you relative to dividends. A capital gain (increase in stock price) permits tax-free compounding and often results in lower tax rates relative to dividends.  

Companies With Low or Negative Earnings

You may notice that some businesses don’t generate earnings or have negative earnings. Yet they still have a non-zero stock price. 

What’s up with that? 

These companies have value because investors expect earnings in the future. Otherwise, there would be no reason to own the company.  

Once upon a time, Apple was one of these guys. It did not generate earnings. During that time, the price of the stock was based on the expectation for future cashflows.

And those cashflows came. Today, 25 years later, Apple pays out a huge chunk ~25% of its earnings as dividends. 

Valuation Changes and Short-Term Returns

If earnings are relatively stable, then where do the crazy short-term swings in stock returns come from?

These come from changes in valuations. 

Valuations represent the price investors are willing to pay for a given amount of earnings. This is expressed as the price-to-earnings (PE) ratio.

The price investors are willing to pay for earnings changes based on:

  • Earnings growth rates.
  • Risk of future earnings.
  • Alternate returns sources, such as bonds (based on interest rates). 
  • Emotional response to events (behavioral).

High valuations influence stock returns, as they decrease dividend yields and increase the likelihood of a short-term drop in valuations.

Today we see low yields and high valuations, primarily in the US market.

It is reasonable to expect the next 10 years of S&P500 returns to be lower than the past decade.

High valuations result in lower future expected returns, and low valuations result in higher future expected returns. 

You may believe this is the reason for market timing. But you are wrong. 

Short Term Returns = Earnings Growth (per share) + Dividend Yield + Changes in Valuation.

In the lost decade from 2000 to 2010, the U.S. market return was negative.  

It was -1.2% annualized for the decade. Unfortunate. Declining valuations overrode earnings growth + dividends. 

This is just another reason why I’ll always be globally diversified.

The Effect of Valuation Changes on S&P500 Returns

Where Do Index Fund Stock Returns Come From?

Let’s ponder about the total earnings generated by a collection of businesses, such as the 500 businesses (stocks) contained in the S&P500 index.

As you may know, I only invest in index ETFs, for a few reasons:

  • Only 1.3% of global stocks are responsible for the net wealth creation of global stock markets (source).
  • The risk associated with the earnings of individual stocks is not compensated with returns. A broad market index fund provides better risk-adjusted returns.
You can learn more about index funds in this post.  
 

The price of the index fund is based on the prices of all stocks that make up the index.

And the prices of these stocks are based on the current and future (expected) earnings of the actual businesses.

S&P 500: 100 Years of Returns 

The history of the S&P500 index returns can be used to test the theory of where long-run stock returns come from. Total Returns = Earnings Growth + Dividends. 
 

S&P500 earnings growth has been 6.2% annually since 1922 with a dividend yield averaging 3.8% (data source). 

Adding these up provides a total return of 10.0% annually since 1922 (6.2% + 3.8%).

That measures up well to the actual return since 1922 of 10.5%. The additional 0.5% is due to an increase in valuations.

An average return of 10% annually is impressive given WWII and the great depression. You can check out The Power of S&P500 reinvested dividends to dig deeper into S&P500 history.

A 100% loss of an index fund’s value means that the earnings potential of all businesses goes to zero. In this case, you have far larger problems to worry about.

Compensation for Risk

When we look at anything in the future, we have to consider risk. T

The price you pay for an investment is based on the future cashflows that you can expect.

These cashflows have risk.

The riskier the cashflows. The lower the price you will pay initially, and the higher the return. A high dividend yield is an example of this.

Conclusion: Where Stock Returns Come From

  • Stock returns come from earnings generated by businesses. 
  • Total returns = Earnings Growth Per Share + Dividends.
  • Dividends are earnings paid to you as cash. 
  • The returns of an index come from the collective dividends and earnings growth from the stocks held within that index.  
  • It doesn’t matter if a business returns money to you via dividends or share buybacks. 
  • Changes in valuations produce short-term price swings. It’s impossible to predict valuation changes. 
  • I do not account for returns from changing valuations in my estimates.   
  • Higher valuations reduce future returns (lower earnings yields), and low valuations increase future returns.