Earnings and dividend growth rate assumptions are a primary factor in almost all fundamental models of common stock valuation. The greater the anticipated future growth in firm earnings, the greater the stock valuation will be, assuming risk remains unchanged.
But estimating earnings growth potential is difficult. Many subjective factors are considered, including the firm’s management, technology, competition and government regulation. Arriving at a numerical estimate of growth for use in valuation requires the use of accounting data and a close look at the components of growth. In fact, an examination of the components of growth allows investors to see what has caused any changes that may have occurred. That, in turn, can have important implications for future earnings growth.
The Determinants of Growth
Security analysts commonly use two determinants of earnings growth: return on equity and changes in stockholders’ equity. In fact, return on equity is usually ranked as one of the most important variables in security selection by security analysts.
Return on equity is used to judge the percentage of return on the equity capital of a firm. It can be simply stated as earnings after taxes divided by common stockholders’ equity. However, this can be broken down into several components: Return on equity is the net proﬁt margin, times the asset turnover, times the firm’s financial leverage (see Table 1).
It is easy to see why these are components of return on equity. The net profit margin—earnings after taxes divided by sales—reflects how efficient a ﬁrm is in operations, administration, financing and tax management per sales dollar. The greater and more stable the net profit margin, the greater and more stable earnings generated by the firm will be.
Asset turnover—sales divided by total assets—shows how well a firm utilizes its asset base to produce sales. Poorly deployed or redundant assets would result in a low asset turnover that would adversely affect return on equity.
Financial leverage—total assets divided by common stockholders’ equity—indicates to what degree the firm has been financed through debt as opposed to equity sources. The greater the value of this leverage ratio, the greater the financial risk of the firm—but also the greater the return on equity. If equity is small relative to debt, then earnings generated will result in a high return on equity. The ideal firm would maintain a high net profit margin, utilize assets efficiently and do it all with low risk, low financial leverage.
As Table 1 indicates, stockholders’ equity is also a key component of return on equity. Thus, changes in this number are often watched by analysts as a clue to earnings growth. Stockholders’ equity consists of retained earnings along with capital paid into the ﬁrm through the sale of common stock. For most firms, the item most likely to change is retained earnings. In analyzing changes in stockholders’ equity, the key variables are book value per share and the payout, or retention, ratio (Table 2 breaks down their components).
Generally, firms with many proﬁtable investment opportunities, growth firms, retain a substantial portion of their earnings. Some firms reinvest all earnings and consequently choose not to pay out any earnings in dividends. Book value per share increases with retention of earnings and also when new common stock is sold at share prices greater than book value per share. Conversely, book value per share would decrease if new common stock were sold at a price below book value per share. The critical point is not how much a firm is retaining and reinvesting, but how well these earnings have been invested. Multiplying return on equity with the retention ratio gives the rate of growth in earnings per share (see Table 3).
Analyzing Earnings Growth
Growth in earnings is equivalent to growth in stockholders’ equity, if there has been no accounting changes that would affect stockholders’ equity and there were no common stock sales over the period. Analyzing changes in variables that determine return on equity and retention policy allows investors to formulate more clearly expectations of future growth. Comparisons to past years reveal important trends and explain dynamic changes in firm performance. The example in Table 4 illustrates the steps of an internal growth analysis for Hypothetical Inc. From that data are derived the major determinants of firm growth. This is presented in Table 5. The results:
- Net profit margin: 1982—0.03558; 1983—0.03665
- Asset turnover: 1982—2.232; 1983—2.272
- Financial leverage: 1982—2.653; 1983—2.558
- Return on equity: 1982—0.210; 1983—0.213
From this simple analysis, it is evident that Hypothetical Inc.’s return on equity increased. How it did so is indicated by decomposing return on equity into its components: Hypothetical Inc. improved its net profit margin, increased its asset turnover and reduced its financial leverage from 1982 to 1983. But despite the decrease in financial leverage, which has a negative impact on return on equity, the increase in profit margin and asset turnover more than offset it. As a result, return on equity increased.
This analysis format should be extended to at least a five-year historical period to discern any trends and also to evaluate the stability of these variables over the business cycle.
The analysis can also be performed in more detail, by breaking down the components even further. For example, rather than using net profit margin that has already implicitly considered interest and taxes, one could use margin before interest and taxes have been deducted to explicitly evaluate interest cost and tax management. Table 6 illustrates this analysis. By explicitly incorporating interest into the return on equity calculation, the impact on income of financial leverage due to interest can be evaluated.
Using this analysis on the Hypothetical Inc. data, the growth rate in earnings can be analyzed. Since earnings growth is the retention rate times the return on equity, the growth in earnings for 1982 was 20.18%, compared with 20.30% in 1983.
The 1983 figure can be verified by increasing the 1982 earnings per share figure by the earnings growth rate: It should equal the 1983 earnings per share. For Hypothetical Inc., with a 1982 earnings per share of $1.80, you would have: $1.80 + ($1.80 x 20.30%) = $2.16. This compares with the actual 1983 figure of $2.15. The slight difference in earnings per share is due to small changes in the number of common shares outstanding during the year and the use of year-end values.
The growth in earnings figure should also cause an increase in the 1982 shareholders’ equity figure to approximate the 1983 shareholders’ equity figure; the two will be equal only if no new shares of common stock are sold over the year. For Hypothetical Inc., with a 1982 stockholders’ equity of $8.50, the growth is: $8.50 + ($8.50 x 20.30%) = $10.22. This compares with the actual 1983 stockholders’ equity of $10.20. The few cents difference is due, as before, to a small change in common shares outstanding over the year.
If these trends persist, it can be expected that earnings and book value at Hypothetical Inc. will grow at about 20% annually. Of course, an in-depth evaluation of future earnings would require many more years of data. It would also require a subjective analysis of factors such as management, product innovation, competition, government regulation, material costs, management and other pertinent variables.
In addition, any analysis of this type would not be complete without a comparison of the firm against the industry to detect how the firm has handled the product marketing and operating environment shared by other firms in the industry.
However, the analysis provides investors with a numerical estimate of future earnings growth, which can be used along with other analyses for fundamental common stock valuation.
This article was written by John Markese for the June 1984 issue of the AAII Journal. At the time, Markese was director of research at the American Association of Individual Investors and also an associate professor of finance at DePaul University, Chicago. Markese is also the former president of AAII.