Earnings growth

Earnings growth is the annual rate of growth of earnings from investments.

Overview

Generally, the greater the earnings growth, the better.

When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate.

Earnings growth rate is a key value that is needed when the DCF model, or the Gordon's model is used for stock valuation.

The present value of stock is given by

P = D\cdot\sum_{i=1}^{\infty}\left(\frac{1+g_i}{1+k}\right)^{i}

where P = the present value, k = discount rate, D = current dividend and $g_i$ is the revenue growth rate for period i.

If the growth rate is constant for $i=n$ to $\infty$ , then,

P = D\cdot\frac{1+g_1}{1+k} + D\cdot(\frac{1+g_2}{1+k})^2 +...+ D\cdot(\frac{1+g_n}{1+k})^n+ D\cdot\sum_{i=n+1}^{\infty}\left(\frac{1+g_\infty}{1+k}\right)^{i}

The last term corresponts to the terminal case. When the growth rate is always the same for perpetuity, the Gordon's model results:

$P = D\times\frac{1+g}{k-g}$ .

As the Gordon's model suggests, the valuation is very sensitive to the value of g used.^[1]

Note that part of the earnings is paid out as dividends and part of it is retained to fund growth, as given by the payout ratio and the plowback ratio. Thus the growth rate is given by

$g = {Plowback\ ratio}\times {return\ on\ equity}$ .

Note that for S&P500, the return on equity has ranged between 10 to 15% during the 20th century, the plowback ratio has ranged from 10 to 67% (see payout ratio).

Other related measures

It is sometimes recommended that revenue growth should be checked to ensure that earnings growth is not coming from special situations like sale of assets.

When the earnings acceleration (rate of change of earnings growth) is positive, it ensures that earnings growth is likely to continue.

Historical growth rates

According to economist Robert Shiller, earnings per share on the S&P 500 grew at a 3.8% annualized rate between 1874 and 2004 (inflation-adjusted growth rate was 1.7%).^[2] Since 1980, the most bullish period in U.S. stock market history, real earnings growth according to Shiller, has been 2.6%.

The table below gives recent values of earnings growth for S&P 500.

Date	Index	P/E	EPS growth (%)	Comment
12/31/2007	1468.36	17.58	1.4
12/31/2006	1418.30	17.40	14.7
12/31/2005	1248.29	17.85	13.0
12/31/2004	1211.92	20.70	23.8
12/31/2003	1111.92	22.81	18.8
12/31/2002	879.82	31.89	18.5
12/31/2001	1148.08	46.50	-30.8	2001 contraction resulting in P/E Peak
12/31/2000	1320.28	26.41	8.6	Dot-com bubble burst: March 10, 2000
12/31/1999	1469.25	30.50	16.7
12/31/1998	1229.23	32.60	0.6
12/31/1997	970.43	24.43	8.3
12/31/1996	740.74	19.13	7.3
12/31/1995	615.93	18.14	18.7
12/31/1994	459.27	15.01	18.0
12/31/1993	466.45	21.31	28.9
12/31/1992	435.71	22.82	8.1
12/31/1991	417.09	26.12	-14.8
12/31/1990	330.22	15.47	-6.9	July 1990-March 1991 contraction.
12/31/1989	353.40	15.45	.
12/31/1988	277.72	11.69	.	Bottom (Black Monday was October 19, 1987)

The Federal Reserve responded to decline in earnings growth by cutting the Intended federal funds rate (from 6.00 to 1.75% in 2001) and raising them when the growth rates are high(from 3.25 to 5.50 in 1994, 2.50 to 4.25 in 2005).^[3]

P/E ratio and growth rate

The growth stocks generally command a higher P/E ratio because their future earnings are expected to be greater. In Stocks for the Long Run, Jeremy Siegel examines the P/E ratios of growth and technology stocks. He examined Nifty Fifty stocks for the duration December 1972 to Nov 2001. He found that

Portfolio	Annualized Returns	1972 P/E	Warranted P/E	EPS Growth
Nifty Fifty average	11.62%	41.9	38.7	10.14%
S&P 500	12.14%	18.9	18.9	6.98%

This suggests that the significantly high P/E ratio for the Nifty Fifty as a group in 1972 was actually justified by the returns during the next three decades. However, he found that some individual stocks within the Nifty Fifty were overvalued while others were undervalued.

Sustainability of high growth rates

High growth rates cannot be sustained indefinitely. Ben McClure^[4] suggests that period for which such rates can be sustained can be estimated using the following:

Competitive Situation	Sustainable period
Not very competitive	1 year
Solid company with recognizable brand name	5 years
Company with very high barriers to entry	10 years

Relationship with GDP growth

It has been suggested that the earnings growth depends on the nominal GDP,^[5]^[6] since the earnings form a part of the GDP.^[7]^[8] It has been argued that the earnings growth must grow slower than GDP^[9] by approximately two percent.

On-line valuation calculators

http://www.moneychimp.com/articles/valuation/dcf.htm: Discounted Cash Flows Calculator that assumes that a higher growth can be sustained for a limited number of years.
http://intelligentinvesting.googlepages.com/DCF.xls: A DCF spreadsheet that allows different growth rates to be specified for years 1, 2 to 4, 5 to 7 and 8 to 10.

External links

GDP Growth Rates of Major Countries (%) 1979-2007

References

↑ http://www.investopedia.com/university/dcf/dcf6.asp DCF Analysis: Pros & Cons Of DCF
↑ http://www.marketwatch.com/News/Story/8kcdFFrMdjF2qXDNJf15SQf?siteid=mktw&dist=TNMostMailed MARK HULBERT, Trees don't grow to the sky, April 11, 2006
↑ http://www.federalreserve.gov/fomc/fundsrate.htm Intended federal funds rate
↑ http://www.investopedia.com/university/dcf/dcf1.asp DCF Analysis: The Forecast Period & Forecasting Revenue Growth
↑ http://www.ers.usda.gov/datafiles/International_Macroeconomic_Data/Historical_Data_Files/HistoricalCPIsValues.xls CPI
↑ http://www.ers.usda.gov/datafiles/International_Macroeconomic_Data/Historical_Data_Files/HistoricalRealGDPValues.xls GDP
↑ Fed Policy and the Effects of a Stock Market Crash on the Economy - Federal Reserve Board unable to offset effects of market crash Business Economics, April, 2000 by Ray C. Fair http://fairmodel.econ.yale.edu/stockm
↑ http://bigpicture.typepad.com/comments/2007/04/earnings_decele.html Earnings Deceleration and Equity Prices, April 08, 2007
↑ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=489602 Earnings Growth: The Two Percent Dilution, WILLIAM J. BERNSTEIN, ROBERT D. ARNOTT, Research Affiliates, LLC, Financial Analysts Journal, Vol. 59, No. 5, pp. 47-55, September/October 2003

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