Growth, Profitability and Equity Value

• In Event: Valuation

Abstract

In predicting expected cash flows using growth and profitability forecasts, fundamental valuation applications often ignore the correlation between growth and profitability. However, due to economic and accounting effects, growth is strongly correlated with subsequent profitability, implying that valuation models that ignore this correlation are likely to yield biased estimates. We show that the value effect of the growth/profitability correlation on average explains more than 10% of equity value, but its magnitude varies substantially with firm size, volatility, profitability, and expected growth. The covariance value effect is driven by both operating and financing activities, but when it is large it is typically due to operating activities. One implication of our findings is that conducting scenario analysis or using other methods for incorporating the growth/profitability correlation (e.g., Monte Carlo simulations, decision trees) is particularly important when valuing small, high volatility, low profitability, or high growth companies. In contrast, for mature, high profitability companies, covariance effects are typically small and their omission is not likely to significantly bias the estimates.

Authors

• Meng Li, Columbia University

• Doron Nissim, Columbia University