The second point to be emphasised is that there are two kinds of share price growth,
results from inflation and the retention of earnings,and possibly from general market growth caused by say systematic declinesin the risk premium. Inflation is outside the control of management andretained earnings are simply the residual of the dividend payout. Likewise,the market price for risk is determined by factors outside the control of individual companies. The combination of normal growth in the share priceand dividends provide the normal rate of return to investors. In an efficientmarket all shares are priced to give an expectation of the normal rate of return and, therefore, an expectation of normal growth.
arises when shareholders receive added valueabove the normal rate of return. Thus, if a positive NPV project undertaken by the firm feeds through to the share price this is abnormal growth. It isabnormal growth that is at issue here. When the textbooks suggest thatmanagement should seek SPM they mean they should seek to achieveabnormal growth. Otherwise managers would be motivated to retain allearnings and keep dividends to a minimum.It might seem that defining growth in the share price resulting fromretained earnings as normal is misleading since a company may earn andretain
earnings from its investments. Does adjusting share pricegrowth for retention of abnormal earnings not conceal abnormal share pricegrowth? The answer is no, because abnormal share price growth does notresult from
abnormal earnings, but from the
. For example, assume that a new company is expected to earn15% on every pound it invests when the normal rate of return is 10%. Its £1shares will be valued at 150p, an abnormal growth rate of 50%. If, after thefirst year, the company pays out its abnormal earnings of 15p in dividends,shareholders will earn 15p/150p = 10%, the normal return for the risk class.If the company instead decided to retain its abnormal earnings of 15p, theshares would then be priced at 165p. The growth in the share price from150p to 165p is, again “normal”, being 10%. Therefore, adjusting thegrowth in the share price for retained earnings, whether normal or abnormal,to determine whether there is any abnormal growth is perfectly valid. In thisexample the abnormal growth is zero whether the company pays or retainsits abnormal earnings.