Forecasting Growth Rates In Valuations

Forecasting Growth Rates In Valuations

The most challenging aspect of #valuations is forecasting the growth rates and whether the growth improves earnings quality. Buyers predict growth rates on historical trends and industry averages or rely on equity research reports and management projections. However, in my view, growth is not an exogenous variable. Instead, growth is a function of a firm’s reinvestment for future growth and the quality of its reinvestment.

Let me substantiate my above hypothesis from an equity investor’s perspective in a firm. #RoE is a function of #EPS and Net income for equity investors.

ROE = Net Income/Equity Capital

If the firm makes an acquisition and issues new equity with funding the acquisition, the ROE on the acquisition > the pre-deal ROE of the firm. If that does not happen, the quality of earnings and cash flows declines, affecting the stock price despite EPS increases.

For instance, in year 1, the net income of the firm A= $100
Book value of equity of Firm A = $1000
RoE = 10%
No of shares outstanding = 1000
EPS = 0.1

Firm A acquires another company at $500 (5x net income) and issues equity (333 shares at $1.5/share) to fund this deal.

In Year 2, Net Income of Firm A = $150
New shares issued = 333.33
No of shares = 1333.33
Market cap of Firm A = $2000
EPS = 0.11

The marginal RoE for this acquisition = ($150-100)/(2000-1000) = 5%
Reinvestment rate = $1000/100 = 1000%
Growth in Net Income = 5% *1000% = 50%

Despite the increase in Net Income growth by 50% and EPS growth by 13%, the investors would reject this transaction because of marginal RoE from this acquisition (5%) < Pre-deal RoE (10%).

In my view, growth is essential for the investor, but the quality of development is most important for the investor, which RoE measures.