What is Growth?

The term growth is often used vaguely, or with a variety of meanings. People talk of “growth firms” – and of
paying more for a growth firm – but their meanings is not always clear. Sometimes the term is used to mean
growth in sales, sometimes growth in earnings, and sometimes growth in assets. Generally growth is seen as a
positive attribute, an ability to generate value. But what is a growth firm?
The valuation models provide the answer to this question. One pays a premium over book value based on the
ability of a firm to grow residual earnings (RE), where residual earnings is the difference between earnings and
the required return on book value. For any year t,
tttEt1 Residual earnings (RE ) Earnings [( 1) Shareholders'equity ] − = − r − ×
where ) 1(E −ris the required return for equity. Shareholders invest in firms, and the book value of their equity —
the firm’s net assets — measures this investment. Firms apply the net assets in operations to add value for
shareholders. Residual earning measure the value added to book value over that required to cover the cost of
capital. So a sensible way of viewing growth that ties into value creation is into terms of growth in residual
earning: A growth firm is one that can grow residual earnings.
One pays more than a normal P/E based on the ability of a firm to generate abnormal earnings growth (AEG),
where abnormal earnings growth is the difference between cum-dividend earnings and a charge for the prior
year’s earnings growing at the required rate. For any year t,

Abnormal earnings growtht (AEGt) = [Earningst + (rE- 1)dt-1] - rE Earningst-1

Where dt-1 is the net dividend paid in the prior year. Firms do not add to their P/E ratio if they can only grow
earnings at the required rate of growth. They add value only if they can grow earnings at a rate greater that the
required rate, that is, if they can deliver abnormal earnings growth. So another way of viewing growth that ties
into the value creation is in terms of the ability of a firm to deliver abnormal earnings growth.

We should be warned against paying too much for earnings growth. We emphasized that earnings growth alone
is not a good measure of growth because earnings growth can be created by investment (that does not add value)
and by accounting methods (that also do not add value). We showed how residual earnings and abnormal
earnings growth measures isolate that part of earning growth that is to be valued from that part which is not.
Charging earnings for required earnings- required earnings on book value in the case of residual earnings and
required earnings on prior earnings in the case of abnormal earnings growth – protects the investor from paying
too much for earnings growth created by investment and accounting methods. In short, residual earnings growth
and abnormal earnings growth are the growth measures we must focus on if we have valuation in mind.
Residual earnings are the relevant growth measure when evaluating the price-to-book (P/B) ratio. Abnormal
earnings growth is the relevant growth measure when evaluating the price-earnings (P/E) ratio. However, the
two measures are just different ways of looking at the same thing: Abnormal earnings growth is equal to the
change in residual earnings. If a firm has no growth in residual earnings, its abnormal earnings growth must be
zero: The firm is a “no growth” firm. If a firm has residual earning growth it must also have abnormal earnings
growth: The firm is a “growth company.” For most of this study note, we will analyze growth in residual
earnings with the understanding that the factors that grow residual earnings also produce abnormal earnings
growth. Residual earnings growth involves both balance sheet and income statement features, so we gain a
better appreciation of the determinants of growth from the analysis of growth in residual earnings.
Table 6.1 introduces you to some growth and no-growth firms. In each case, observe that abnormal earnings
growth is equal to the change in residual earnings.