- Earnings growth
How to understand these 3 drivers?
Assume if a stock costs $100 per share and has earnings per share of $10. If its earning grows by 5% to $10.50, the stock price should grow by a commensurate 5%, to $105, assume everything else remains the same, a 5% return.
But stock prices reflect what investors expect in the future, which impacts valuations, commonly represented by a measure such as Price-Earnings Ratio (PE). If investors are bullish on a stock, they will bid up the price, thus expanding the stock's PE ratio. Say the $100 stock with $10 earnings has a PE ratio of 10, now confident investors bid the price up to PE ratio of 12, the stock now trades at $120, a 20% return.
Dividends are what the company gives back to investors, it is the least volatile and don't ever detrack from the market's returns. As a result, reinvested dividends have an outsize impact on the market's return over time.
The chart below shows how these 3 drivers impact stocks' returns over the past decade.