A new year is a chance to start fresh, regardless of the prior year’s up or down return. Let’s re-examine where returns come from, so we can isolate the source of performance and use that to make rational investment decisions going forward. I intend for this to be a yearly reprint because I view the message as centering as we all reset and focus on the new year.
The Grinold-Kroner Model
Unlike many financial formulas, the Grinold-Kroner model is relatively straightforward.
Ri = (D1 / P0) + i + g - ∆S + ∆(P/E)
It shows that an asset’s total return is comprised of 3 main components:
- Income return: D1 / P0 (Dividend Yield)
- Nominal Earnings per share Growth: (g + i - ∆S) (i stands for inflation, ∆ is the change in shares outstanding. A reduction in shares outstanding bumps up earnings per share, all else equal.)
- Valuation Change: ∆(P/E)
As Einstein once said, try to make things as simple as possible but no simpler. This model certainly fits the bill. To illustrate this, let’s provide a couple examples:
Stock A: Earnings Growth Example
Initial stock price: $100
Dividend yield: 2%
Earnings growth: 10% (for example, $10 in earnings last year and $11 in earnings next year)
Valuation change: 0% (P/E has remained unchanged at 10 for the year)
Stock A Return = 2% + 10% + 0% = 12%
The dividend income return is straightforward: 2%. To illustrate the earnings and valuation effect, let’s use earnings of $10 and $11 to represent the 10% growth and a consistent 10 times earnings for the valuation since it’s unchanged. In this case, the stock will have grown from $100 to $110 over the course of the year. The total return is $2 for the dividend (2% * 100) plus $10 dollars in price appreciation: (12 / 100 = 12%).
In this example, investors weren’t any more positive or negative about the company. The business’s earnings simply grew, and the price reflected that earnings growth, resulting in a 12% percent return for the investor. Similarly, if the business shrank to $9 in earnings, for example, investors would experience a negative return slightly offset by the dividend income (-$10 in price appreciation + $2 in dividend income: -8 / 100 = -8%).
Stock B: Valuation Expansion Example
Initial Stock Price: $100
Dividend yield: 2%
Earnings growth: 0% ($10 in earnings unchanged throughout the year)
Valuation change: 10% (P/E goes from 10 last year to 11 the next year)
Stock B Return = 2% + 0% + 10% = 12%
The dividend yield is the same as before. Following the previous example, let’s use earnings of $10 per share, which doesn’t change. In this example, the stock price rises from 100 to 110 ($10 in earnings valued at 11x rather than 10x). Add in the dividend income and the total return is $2 plus the $10 price change from valuation to get a total return of 12% (12/100 again!)
In this example, the company didn’t grow at all. However, the price increase could be due to higher optimism about the prospects of the business. Alternatively, if investors were negative about future business prospects and assessed it at a lower valuation, all else equal, the return would be negatively impacted.
Short-Term vs. Long-Term
A common theme in my writing has been the focus on return on invested capital (ROIC), the company’s ability to grow and reinvest earnings, and the way it finances itself. This approach leans towards the earnings growth side of the equation as opposed to the valuation component because it is far less volatile and centers on the business versus investor sentiment. You and I cannot control how investors feel about a business at any given time, but a portfolio of businesses skewed towards long-term earnings growth results in a much more predictable trajectory for portfolio appreciation than hoping someone else consistently purchases your shares at a higher price.
Though long-term results are governed primarily by earnings growth, short-term results are impacted by valuation multiples. To see the degree in action, look at the past few years of earnings relative to the high and low prices each year for Microsoft (MSFT):
SOURCE: MarketSurge. Microsoft EPS & Yearly High and Low Prices (Fiscal Year ended June) (January 12, 2026)
Despite earnings consistently rising year over year and resulting in MSFT shares reaching new highs in most of those years, the difference in the high and low prices for the year is wildly dispersed. This means that in any given year, valuations may change dramatically. As a result, the ability to predict multiple growth is much less certain than earnings growth.
To be a long-term holder of a stock, you must be confident enough in a business’s ability to grow its earnings consistently, accept the yearly swing in highs and lows, and hold throughout. Otherwise, the volatility will shake you out.
All too often, investing is portrayed as some sort of crystal-ball affair with no rhyme or reason as to how stocks behave. In any given year, the valuation of a business may swing mightily; no equity investor can escape this perennial dynamic. What does lie in an individual investor’s control is assessing what businesses over time should be able to increase earnings at a respectable rate and creating rules to avoid making rash or emotional decisions they may regret.
Dean Schwefel, CFA®
Senior Investment Analyst
Disclaimer: Investing involves risks, and investment decisions should be based on your own goals, time horizon, and tolerance for risk. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. The forecasts or forward-looking statements are based on assumptions, may not materialize, and are subject to revision without notice. The market indexes discussed are unmanaged, and generally, considered representative of their respective markets. Index performance is not indicative of the past performance of a particular investment. Indexes do not incur management fees, costs, and expenses. Individuals cannot directly invest in unmanaged indexes. The author, or the advisor with whom the author is affiliated, has an interest in the securities mentioned in the above article/blog post. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.