Earnings Growth and Growth in Earnings Growth as Value Drivers

• In Event: Valuation, cost of equity, and expected returns
  In Paper Session: EValuation, Cost of Equity, and expected Returns

Abstract

This study develops a model that anchors value on double capitalized earnings growth and adds extra value for expected growth in earnings growth. The model permits three growth parameters in the residual earnings (RE) dynamic – one for the long-term RE (g), one for the short-term RE (gh), and one for the short-term RE growth (gv). It can be transformed into: V0=BV0+((RE1/(r–g))∙Scalar’, where Scalar’=1+(gh–g)/r+(gv-g)∙gh/r2. The model is reduced to the Ohlson and Juettner-Nauroth (2005, OJ) model under gv=g, and further reduced to the Ohlson (1995) RE model under gv=gh=g. The generalization leads to generalized expressions for PB, PE, and PEG ratios as a function of (ROE, r, gv, gh, and g), offering new insights. Even when ROE>r and gh>0, a sufficiently negative gv can lead to PB<1 and PE<1/r. In addition, PEG ratios are not generally one or 1/r2, and increase with growth in earnings growth. Finally, the model accommodates richer RE growth rate patterns. Positive (gv-g)∙gh (the third item in Scalar’) admits a ‘frown’ shaped pattern where the RE growth rate reverts from gh to g with a temporary boost in the medium-term. Conversely, a negative value allows a ‘smile’ shaped growth rate pattern that captures a temporary slump.

Author

• Cheng Lai, ESSEC Business School