The Growth Illusion: The P/E ‘Cost’ of Earnings Growth

Abstract

It is intuitively tempting to view firms with high earnings growth as offering special value. Indeed, standard dividend discount models seem to equate price growth with earnings growth. But a firm can show substantial earnings growth-by increasing earnings retention, for example, or reinvesting at available market rates-without creating a single dollar of extra value for shareholders. The significance of realized earnings growth becomes apparent only after one has determined the baseline level of PIE growth (or decline) consistent with the firm's initial prospects and valuation. One must then examine carefully the firm's franchise opportunities-its ability to invest in lines of business that offer more than the market rate of return. The firm's current earnings growth may be in relation to the market average, yet not excessive at all given its expected franchise opportunities. High earnings that derive from franchise opportunities already embedded in the firm's PIE reflect management's exploitation of preexisting opportunities. In effect, this exploitation represents a drawdown of the franchise value incorporated in PIE and suggests an inverse relation between realized earnings growth and realized PIE. Only if management has the skill or luck to extend the firm's franchise opportunities beyond those already embedded in the firm's valuation will excess earnings growth represent added value to shareholders.