How Equities Generate Returns
Equity is an ownership stake in a business. When you buy a share of Infosys or hold a Nifty 50 index fund, you are buying the right to a proportional share of the company's future profits.
The return you earn from equity comes from three sources:
1. Earnings growth. As a company's profits grow, the intrinsic value of its equity rises. Over long periods — 10 years or more — earnings growth is the dominant driver of equity returns. For the Nifty 50 as a whole, nominal earnings growth (real GDP growth + inflation) has historically been in the 10–12% range annually.
2. Change in valuation multiple. The price you pay per rupee of earnings (the P/E ratio, or price-to-earnings multiple) can expand or contract. In a bull market, investors become more willing to pay premium multiples for future earnings. In a bear market, multiples compress even if earnings hold up. Valuation multiple changes explain the difference between short-term and long-term equity returns. Over very long horizons, P/E reversion dampens returns if you buy at high multiples, and boosts returns if you buy at low multiples.
3. Dividends. Cash paid directly to shareholders out of company profits. For the Nifty 50, the dividend yield is approximately 1.2–1.5%. Dividends are a more stable component of return, but less significant in India than in mature markets where dividend payout ratios are higher.
Putting it together with the Gordon Growth Model:
$$r_{equity} = \frac{D_1}{P_0} + g = \text{Dividend yield} + \text{Earnings growth}$$
where $D_1$ is next year's expected dividend, $P_0$ is today's price, and $g$ is the long-run sustainable earnings growth rate. For the Nifty 50 today:
- Dividend yield ≈ 1.2%
- Sustainable nominal earnings growth ≈ 10–11% (6–7% real + 4–5% inflation)
- Implied expected return ≈ 11–12%
This is the expected return for an investor who buys at today's valuation level and holds for many years. The actual realised return can differ significantly in any given year.
Risk in equity:
Equity's primary risk is the market risk premium — the compensation for holding an asset that falls sharply during economic contractions. The Nifty 50 has experienced drawdowns of 50–60% (2008 GFC) and 35–40% (2020 COVID) from peak to trough. These are normal occurrences for equity investors on a 20+ year horizon.
Additional equity risks:
- Earnings risk: Company profits can decline in recessions, reducing intrinsic value.
- Valuation risk: Even if earnings grow, if P/E ratios compress (as they tend to when rates rise), returns suffer.
- Currency risk: For international equity held by Indian investors, INR appreciation would reduce INR-denominated returns.