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.
The present value of stock is given by
where P = the present value, k = discount rate, D = current dividend and is the revenue growth rate for period i.
If the growth rate is constant for to , then,
The last term corresponts to the terminal case. When the growth rate is always the same for perpetuity, the Gordon's model results:
As the Gordon's model suggests, the valuation is very sensitive to the value of g used.
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%). 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|
|12/31/2001||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|
|12/31/1990||330.22||15.47||-6.9||July 1990-March 1991 contraction.|
|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).
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%|
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 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, since the earnings form a part of the GDP. It has been argued that the earnings growth must grow slower than GDP by approximately two percent.
- Discounted cash flow model
- 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