Decomposing equity returns: Earnings growth versus multiple expansion

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Over the past decade, the stock market has been dominated by the US economy, led by big tech and driven by strong earnings growth and multiple expansion. Companies such as Apple, Microsoft, and Nvidia have fueled this rally, pushing US equities to record weights in global indices and high valuations versus historical norms and other markets. Compared to US growth stocks, European equities, emerging markets (EM), value stocks, low-volatility stocks, and small-cap stocks appear relatively cheap. But do these alternatives present the same investment case?

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To explore this, we decompose equity returns into earnings growth and multiple expansion. This analysis highlights key differences behind underperformance. Small-cap and low volatility stocks delivered strong earnings growth but lagged due to stagnant valuations. EM equities, however, struggled due to weak earnings growth, despite rising valuations. Taiwan and India were exceptions, posting solid earnings growth, though not enough to offset poor performance from China, Korea, and EMEA.

Ultimately, small-cap and low volatility stocks suffer from a lack of investor appreciation, while EM equities need a turnaround in operating performance.

Key findings: What drove performance?

Our approach follows John Bogle’s return decomposition formula:
Return = Dividend Yield + Earnings Growth +/- Change in P/E Ratio

This framework helps distinguish between returns driven by fundamentals – dividends and earnings growth – and those influenced by valuation changes. We applied this method to MSCI country and style indices over a ten-year period (2015-2024) to analyze regional and style-based return drivers.

US equities outperformed
The US market led global performance, benefiting from both the highest earnings growth and significant multiple expansion.
Europe & Japan: modest growth, little valuation expansion
These regions saw lower earnings growth and little multiple expansion, leading to weaker total returns.
EM struggled, with some exceptions
Despite rising valuations, EM equities suffered from weak or even negative earnings growth. Taiwan and India posted strong earnings, but underperformance in China, Korea, and EMEA weighed on the region. LatAm struggled due to multiple contraction.
Small-cap and low volatility stocks: strong earnings, but out of favor
Small-cap stocks consistently delivered stronger earnings growth than large caps. Based purely on fundamental returns, European small caps led all indices. However, their stagnant valuations constrained total returns, particularly in the US. Similarly, low volatility stocks posted robust earnings growth but failed to see valuation increases.
Value vs. growth stocks: US growth stocks dominate
US growth stocks outperformed, fueled by both earnings growth and multiple expansion. Even US value stocks beat growth stocks in Europe, Japan, and EM. In EM, both value and growth stocks suffered negative earnings growth, though EM growth stocks benefited more from multiple expansion, while EM value stocks gained from dividends.

Is a turnaround in sight?

US growth stocks are still going strong. Although earnings growth dipped in 2019-2020 and valuations contracted in 2021-2022, both have since rebounded. However, EM equities have shown little sign of a sustained recovery, with earnings stuck in a cyclical but flat trend.

What does this mean for investors? History suggests that dividends and earnings growth are the main driver of long-term returns, with valuation multiples prone to mean-reverting. While US growth stocks may continue to lead, the healthy fundamentals of small-cap and low volatility stocks indicate potential future opportunities. Earnings in EM will also rebound at some point, and, if the US earnings cycle peaks, US stocks could face multiple contraction.

Rather than extrapolating past trends, investors should prepare for a shifting market environment. A well-diversified portfolio across regions, sectors, and asset classes remains essential for resilience, regardless of how the next decade unfolds.

Download the full paper here