Length of High Growth Period and Barriers to Entry

Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is Earthlink Network, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a biotechnology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period?

a. Earthlink Network b. Biogen c. Both are well managed and should have the same high growth period b. Expected Dividends during High Growth Period

The first step in estimating expected dividends during the high growth period is to estimate the expected earnings for each year. This can be done in one of two ways - you can apply an expected growth rate to current earnings or you can begin by estimating future revenues first and then estimate net profit margins in each year. The first approach is easier but the second approach provides for more flexibility since margins can change over time. The resulting expected earnings are paired with estimated dividend payout ratios in each period, which may change over the high growth period. This may seem like an awkward procedure, since expected dividends could well be estimated using the current dividends and applying a dividend growth rate, but it is used for two reasons. First, most analyst projections for growth are stated in

Historical Growth Rate (in Earnings): This is the growth rate over the past few periods in earnings - it can be calculated either by averaging the year-specific growth rates (arithmetic average) or by estimating at the compounded growth rate over the whole period.

terms of revenues and earnings rather than dividends. Second, separating earnings forecasts from dividend payout provides more flexibility in terms of changing dividend payout ratios as earnings growth rates change. In particular, it allows us to raise dividend payout ratios as earnings growth rates decline.

The growth rate in earnings can be estimated using one of three approaches. The first is to look at the past and measuring the historical growth rate in earnings over previous years. In measuring earnings growth, we will have to consider both how far back to go in time and whether to use arithmetic average or geometric average growth rates. In general, geometric growth rates yield more meaningful values than arithmetic average growth rates. The second is to look at estimates made by others following the same stock. In fact, growth estimates made by equity research analysts following a stock are public information and are easily accessible.5 The third is to consider fundamentals and to estimate a growth rate based upon a firm's investment policy. In particular, the growth in earnings per share of a firm can be written as the product of two variables - the percentage of the earnings per share that is retained in the firm to generate future growth (retention ratio) and a the return earned on equity in these new investments: Expected Growth Rate = Retention Ratio * Return on Equity Thus, a firm with a return on equity of 20% and a retention ratio of 70% should have earnings growth of 14% a year. Reverting back to our discussion of dividend policy in chapter 10, note that the retention ratio and the payout ratio are two sides of the same coin:

Retention Ratio = 1 - Payout Ratio Since the retention ratio cannot exceed 100%, the expected growth in earnings per share in the long term for a firm cannot exceed its return on equity.

Assuming that we can obtain all three estimates of the growth rate in earnings for a firm, which one should we use in valuing a company? Historical growth should be weighted the least, because earnings are volatile and past growth has generally not been

5 I/B/E/S, First Call and Zacks all track equity research analyst forecasts continuously and the consensus estimate across all analysts is publicly available.

highly correlated with future growth.6 Analyst estimates are useful signposts of what the investment community thinks about a company and could include information that is not be in the financial statements. In particular, it could reflect changes in both the company's management and strategic plans. However, trusting analysts, no matter how well informed they may be, to come up with the most important input in a valuation is not prudent. Ultimately, the fundamental growth equation offers the most promise because it relates growth back to what the firm does and also constrains us to pay for growth (by requiring firms to reinvest) as we estimate value.

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