# Earnings growth

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Earnings growth

In investments, earnings growth refers to the annual rate of growth of earnings. When the dividend payout ratio is 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

:$P = Dcdotsum_\left\{i=1\right\}^\left\{infty\right\}left\left(frac\left\{1+g_i\right\}\left\{1+k\right\} ight\right)^\left\{i\right\}$ .

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,

:$P = Dcdotfrac\left\{1+g_1\right\}\left\{1+k\right\} + Dcdot\left(frac\left\{1+g_2\right\}\left\{1+k\right\}\right)^2 +...+ Dcdot\left(frac\left\{1+g_n\right\}\left\{1+k\right\}\right)^n+ Dcdotsum_\left\{i=n+1\right\}^\left\{infty\right\}left\left(frac\left\{1+g_infty\right\}\left\{1+k\right\} ight\right)^\left\{i\right\}$

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

$P = D imesfrac\left\{1+g\right\}\left\{k-g\right\}$.

As the Gordon's model suggests, the valuation is very sensitive to the value of g used. [http://www.investopedia.com/university/dcf/dcf6.asp DCF Analysis: Pros & Cons Of DCF]

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

$g = \left\{Plowback ratio\right\} imes \left\{return on equity\right\}$.

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 Economics 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%). [http://www.marketwatch.com/News/Story/8kcdFFrMdjF2qXDNJf15SQf?siteid=mktw&dist=TNMostMailed MARK HULBERT, Trees don't grow to the sky, April 11, 2006] 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). [http://www.federalreserve.gov/fomc/fundsrate.htm Intended federal funds rate ]

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 Seigal 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 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.

ustainability of high growth rates

High growth rates cannot be sustained indefinitely. Ben McClure [http://www.investopedia.com/university/dcf/dcf1.asp DCF Analysis: The Forecast Period & Forecasting Revenue Growth] 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, [http://www.ers.usda.gov/Data/Macroeconomics/Data/HistoricalCPIsValues.xlsCPI] [http://www.ers.usda.gov/Data/Macroeconomics/Data/HistoricalRealGDPValues.xls GDP] since the earnings from a part of the GDP. [Fed Policy and the Effects of a Stock Market Crash on the Economy - Federal Reserve Board unable to offset effects of market crashBusiness 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] It has been argued that the earnings growth must must grow slower than GDP [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 ] by approximately two percent.

On-line valuation calculators

* [http://www.moneychimp.com/articles/valuation/dcf.htm 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 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.

ee also

*Discounted cash flow model

* [http://investintaiwan.nat.gov.tw/en/env/stats/gdp_growth.html GDP Growth Rates of Major Countries (%) 1979-2007]

References

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