Growth rate is an important input in the processes of valuing a stock
The fundamental growth rate in EPS is the output obtained by multiplying the return on equity (ROE) with the retention rate.
Investment advisors often suggest investing in a particular company because its growth rate is sound. However, many investors are unsure about making inferences on growth rate.
Growth rate Growth rate of a variable is computed by dividing current period number by the previous period number and subtracting 1 from the output. If it is multiplied by 100, then we get growth rate in per cent. This is known as simple growth rate. Compounded growth rate is computed by subtracting 1 from the output obtained by (current period figure/figure for period of comparison) power of 1/n. Here “n” is the difference between the current period and the compared period. For instance, it is 5 if we compute the compounded growth rate in revenue for the calendar year 2020 in comparison to the calendar year 2015.
Variables for growth rate computation Growth rate is computed on variables such as revenue, cost of goods sold, selling general and administration expenses (SGA), gross profit, Ebitda, operating income, profit before tax, net income, earnings per share, current assets, non-current assets, current liabilities, long term liabilities, shareholders funds, operating cash flow, investing cash flow and financing cash flow, etc.
Growth rate for equity investors Equity investors’ fortune is affected by the growth rate in earnings per share (EPS) of their firms. Hence, growth rate in operating income or Ebitda or any other variables are not directly used in the valuation of equity claims. Further, value of a stock is the present value of expected cash flows of the firm in its future. Hence, the growth rate one needs to look at is not the historical actual growth rate but the expected future growth rate. After all, investors are investing their hard-earned funds for future returns. We normally consider growth rate in basic EPS as the quantum of dilution differs on a periodic basis.
Determinants of EPS growth rate The fundamental growth rate in EPS is the output obtained by multiplying the return on equity (ROE) with the retention rate. Retention rate is computed by subtracting dividend payout from one. For instance, let us assume a firm having dividend payout of 60% and ROE of 15% in its calendar year 2020. And the firm is expected to have the same DPR and ROE figures in its future. Then, the fundamental growth rate for SADL is 6% which is computed as 15% (1-0.60). This firm can increase its growth rate in earnings for equity investors either by improving its ROE or by increasing its retention rate or by doing both.
Analysts estimate of growth rate If SADL is followed by analysts, then we can arrive at the average expected growth rate by the analysts. This is called analysts consensus growth rate in EPS for the firm. Growth rate is an important input in the processes of valuing a stock. Hence, investors need to know the meaning, variants, and the determinants of growth rate to maximise their returns.
The writer is an associate professor of finance, XLRI School of Management, Jamshedpur