With both historical and analyst estimates, growth is an
exogenousvariablethataffectsvaluebutisdivorcedfromthe
operating details of the firm. The soundest way of
incorporating growth into value is to make it
endogenous—thatis, tomakeitafunction ofhowmucha
firm reinvests for future growth and the quality of its
reinvestment. We begin by considering the relationship
betweenfundamentalsandgrowthinequityincome,andthen
moveontolookatthedeterminantsofgrowthinoperating
income.
Growth in Equity Earnings
Whenestimatingcashflowstoequity,weusuallybeginwith
estimates of net income if we are valuing equity in the
aggregate,orearningspershareifwearevaluingequityper
share. In this subsection, we begin by presenting the
fundamentalsthatdetermineexpectedgrowthinearningsper
shareandthenmoveontoconsideramoreexpandedversion
of the model that looks at growth in net income.
Growth in Earnings per Share
Thesimplestrelationshipdetermininggrowthisonebasedon
the retention ratio (percentage of earnings retained in the
firm)and thereturnonequity(ROE)onitsprojects.Firms
thathavehigherretentionratiosandearnhigherreturns on
equityshouldhavemuchhighergrowthratesinearningsper
share thanfirmsthat donot sharethesecharacteristics.To
establish this, note that