PER and Growth
Let us now look at the growth of the benefits in the PER. In order to do this we will set up two scenarios:
- If the ROE is higher than K, the more the benefits grow, the more factor F will grow and therefore, the PER and the price that is paid for the shares. Or in other words, the company is creating value, given that their ROE is higher than the earning power the shareholders are asking for; therefore, the more it grows the better. Keep in mind though, the more it grows, maintaining its financial structure, ROE, etc. Keep in mind also that the growth (g) is limited by the equation 7 we had previously shown. To be specific, we cannot grow above our ROE, supposing we do not distribute dividends. For example, if the pay out is zero (zero dividends) and the ROE is of 20 for 100, we will only be able to grow a 20 for 100 a year. In our example, if g were of 0,12 instead of 0,10 then F would be worth 2 instead of 1,5. In fact if the growth were higher than the ROE the previous formula would lead us to some strange results.
- However if the ROE is less than K, then we are destroying value, since F is less than one, and therefore, the more we grow the lesser the PER will be since we will be destroying more value. In practice it is difficult for this situation to come about, since if the ROE is small, the company will not grow much. The danger would be – and this does commonly occur – that a company with a small ROE becomes determined to grow to where it becomes indebted, and in this case it is clearly destroying value. Therefore, be careful with growth.
- Finally, if growth if of zero, the F factor of creation of value is equal to one, and therefore, we are not creating nor destroying value, and the PER of the XYZ share will be given by the inverse of K.
It is important to keep in mind that growth (g), the ROE and K are related between each other. The higher the ROE the more growth there will be, but most likely the share will be seen as a greater risk.
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