The Origins of Growth: Past Growth, Predicted Growth and Fundamental Growth

Abstract:     
A key input, when valuing businesses, is the expected growth rate in earnings and cash flows. Allowing for a higher growth rate in earnings usually translates into higher value for a firm. But why do some firms grow faster than others? In other words, where does growth come from? In this paper, we argue that growth is not an exogenous input subject to the whims and fancies of individual analysts, but has to be earned by firms. In particular, we trace earnings growth back to two forces: investment in new assets, also called sustainable growth, and improving efficiency on existing assets, which we term efficiency growth. We use this decomposition of growth to examine both historical growth rates in earnings across firms and the link between value and growth. We close the paper by noting that the relationship between growth and value is far more nuanced than most analysts assume, with some firms adding value as they grow, some staying in place and some destroying value.

Number of Pages in PDF File: 55

Keywords: growth, sustainable growth, value, excess returns

JEL Classification: G12, G30

working papers series