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If you buy a share and later sell it at a profit, you have made a return. That's the simple version. The more interesting question is: where did this return actually come from?
Depending on the source of a return, it has different levels of resilience, repeatability and risk. Those who do not separate these sources make poorer decisions about when to hold a position and when not to.
Essentially, there are three sources from which equity returns arise.
The first is earnings growth. The company is earning more than before. Sales increase, margins improve, profits grow. The share price follows because a company that earns more is simply worth more.
The second is multiple expansion. The company does not necessarily earn more, but the market pays a higher price for the same profit. The price/earnings ratio rises. The valuation expands.
The third is capital repatriation. The company distributes profits or buys back its own shares. Dividends and buybacks increase the value per share without the need for operational growth.
In practice, these three sources rarely work in isolation. They overlap, reinforce each other or work against each other. Nevertheless, it is worth separating them.
In the long term, profit growth is the most robust of the three sources. A company that increases its profits over many years is also very likely to increase its share price. Markets may react irrationally in the short term. Over five, ten or fifteen years, however, share prices almost always follow earnings power.
$GOOGL (+0,36%) (Alphabet) is a good example. Anyone who bought the share ten years ago has achieved a return of well over 500 percent. The majority of this was not due to valuation changes. It came about because Alphabet systematically earned more. Revenue has multiplied, operating levers have improved the margin, the cloud segment has grown from zero to billions.
Profit growth is sustainable because it is based on operational realities, not market psychology. At the same time, it is harder to achieve. Not every company grows. And even good companies don't grow at high rates forever.
Multiple expansion is the source that can generate the greatest short-term returns. But it is also the most unreliable.
A simple calculation example. A company earns ten euros per share. The market values it at a P/E ratio of 15, the share price is 150 euros. If the P/E ratio rises to 22 without the profit changing, the share price is suddenly 220 euros. A return of almost 47%, without the company having earned a single euro more operationally.
Phases of falling interest rates favor higher multiples. Improved sentiment, new narratives or capital inflows into a sector can drive valuations. Those who are well positioned achieve quick and impressive profits.
The problem is reversibility. What has been created through valuation expansion can disappear just as quickly through valuation contraction.
$CCO (+2,74%) (Cameco) and other uranium producers have not only benefited from rising spot prices between 2020 and 2024. A significant part of the price gains came from multiple expansion. The market began to take the structural supply deficit seriously and paid higher valuations for it. Those who were positioned early benefited from both sources simultaneously: rising profits and rising multiples. Those who got in late were already paying for the narrative.
In my portfolio, this is one of the lessons I have internalized with the uranium cluster. The structural arguments are still intact. But returns from multiple expansion should be valued differently than returns from operational improvements. The first source can reverse quickly. The second is more fundamentally anchored.
The third source is most often underestimated, especially by investors with a focus on growth.
When a company buys back its own shares, the number of outstanding shares falls. Earnings per share increase as a result, even if total earnings remain constant. Over many years, this effect can be significant.
$HON (-5,39%) (Honeywell) is an example. The company is growing moderately. But Honeywell has systematically returned capital to shareholders over the last few years, through dividends and buybacks. Part of the return on this position has not come from spectacular growth, but from this mechanism: a high-quality company that uses its free cash flow in a disciplined way.
If a company cannot find a better use for its capital than buying back its own shares, this is often a rational decision. Provided the share is not massively overvalued. A buyback at an exaggerated valuation destroys value. If the valuation is fair or favorable, it creates it.
The most attractive investments are often those where all three sources act simultaneously. A company that is growing, fairly valued and also repatriates capital offers a structurally favorable opportunity profile. $GOOGL (+0,36%) is another good example. Growth has been the dominant source for many years. In recent years, Alphabet has also started to buy back significant amounts of its own shares. Capital repatriation has become a complementary source without replacing the growth logic.
The reverse pattern is just as important. If a return has come almost exclusively from multiple expansion, the position is more susceptible to changes in sentiment without anything necessarily having changed operationally.
That's why I regularly look at this question for my positions: Where did the previous return come from? And what will be the source of future returns?
Share returns often look the same in retrospect. A share rises by 80 percent. But this 80 percent can come from completely different sources. From earnings growth, which is likely to continue. From valuation expansion, which can reverse at any time. Or from capital repayments, which are structurally anchored. Profit growth develops its value over time. Multiple expansion unfolds it quickly and takes it away just as quickly.
Capital repatriation works quietly but reliably in the background.
The next article will look at the second of these sources in detail. Multiple expansion is the phenomenon that generates the greatest short-term returns and is also the least understood. What really drives valuation changes? And when do investors pay for it without realizing it?
