Earnings Growth - Overview

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

.

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.

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

.

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).