Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

5-2f HoW to EStIMAtE GRoWtH

By now, it should be apparent that a central component in many share-pricing models is the growth rate.

Unfortunately, analysts face a tremendous challenge in estimating a company’s growth rate, whether that

growth rate refers to dividends, earnings, sales or almost any other measure of financial performance. A

company’s rate of growth depends on several factors. Among the most important, however, are the size

of the investments it makes in new and existing projects and the rate of return those investments earn.

A simple method for estimating how fast a company will grow uses information from financial

statements. This approach acknowledges the importance of new investments in driving future growth.

First, calculate the magnitude of new investments that the company can make by determining its

retention rate, rr: the fraction of the company’s earnings that it retains. Second, calculate the company’s

return on ordinary equity, ROE (see Chapter 2), to estimate the rate of return that new investments will

generate. The product of those two values is the company’s growth rate, g:

Eq. 5.6 g = rr × ROE

example

In its 2016 annual report, Melbourne Minerals

reported net income of $243 million and total

shareholders’ equity of $1,602 million. Therefore,

the company’s ROE was 15.2% ($243 ÷ $1,602).

Melbourne Minerals paid $32 million in cash

dividends that year, so its retention rate was

86.8% (1 – $32 ÷ $243). By taking the product of

the ROE and the retention rate, we can estimate

Melbourne Minerals’ growth rate at 13.2%

(0.152 × 0.868).

An alternative approach to estimating growth rates makes use of historical data. Analysts track a

company’s sales, earnings and dividends over several years in an attempt to identify growth trends. But

how well do growth rates from the past predict growth rates in the future? Unfortunately, the relationship

between past and future growth rates for most companies is surprisingly weak. The fact that growth rates

are largely unpredictable, however, should not come as a great surprise. One of the most fundamental

ideas in economics is that competition limits the ability of a company to generate abnormally high profits

for a sustained period. When one company identifies a profitable business opportunity, people notice,

and entrepreneurs (or other companies) attempt to enter the same business. For example, consider the

proliferation of smartphones and tablet devices following the success of Apple’s iPhone and iPad. As

more and more companies enter, profits (or the growth rate in profits) fall. At some point, if the industry

becomes sufficiently competitive, profits fall to such a low level that some companies exit. As companies

exit, profits for the remaining companies rise again. The constant pressure created by these competitive

forces means that it is rare to observe a company with a consistent, long-term growth trend. Perhaps one

reason that companies such as Microsoft, Intel and Cochlear are so well known is that their histories of

exceptional long-run growth are so uncommon.

5-2g WHAt IF tHERE ARE No dIVIdENdS?

After seeing the different versions of the dividend growth models, students usually ask, ‘What about

companies that don’t pay dividends?’ Though many large, well-established companies in Australia pay regular

dividends, a large number of companies do not pay dividends at all. Younger companies with excellent

growth prospects are less likely to pay dividends than are more mature companies, and recent decades have

Kenneth French, Dartmouth

College

‘Competition is one

of the most pervasive

forces out there in the

economy.’

See the entire interview on

the CourseMate website.

CoURSEMAtE

SMARt VIdEo

Why do you think that some

product lines are more

successful for companies than

others?

thinking cap
question