risk mayincrease equityvalue muchmorethanincreasing
expected growth.
Quality of Investments Effect
Thefocusonexpectedearningsgrowthamonginvestorsand
analystscansometimesblindustoanobviousfact:Notall
growthiscreatedequal,andcompaniesthatgenerategrowth
moreefficiently(withlessinvestment)shouldtradeathigher
equityvaluesthanfirmsthatgeneratethesamegrowthless
efficiently.Thesimplestwaytoseethisistogobacktothe
fundamental determinants of expected earnings growth:
Inourbasecase,weusedareturnonequityof 20 percentand
aretentionratioof 90 percenttoarriveatanexpectedgrowth
rateof 18 percent.Butthereareothercombinationsofreturn
onequityandretentionratiosthatwouldhavegeneratedthe
same growth rate. For instance, a firmwith a 30 percent
returnonequitywouldhavebeenabletogrowitsearningsat
18 percent whileretaining only 60 percent ofits earnings.
Conversely, a firm with a return on equity of 15 percent
would have required a retention ratio of 120 percent to
generateagrowthrateof 18 percent;ineffect,thefirmwould
have to issue new equity each year.
7 Table8.9summarizestheimpactofchangingthereturnon
equity,whilekeepingtheexpectedgrowthrateat 18 percent,
on equity multiples.
TABLE 8.9Return on Equity and Equity Multiples