Growth: rectifying two common mistakes

ABSTRACT

The paper discusses two issues related to ‘growth’. Both lack a proper recognition in the literature. The first concerns growth and accruals. Research practice combines two components of accruals, asset accruals and liability accruals into a ‘net’. This aggregation causes problems: income-increasing asset accruals correlate positively with growth whereas the opposite holds for income-increasing liability accruals and growth. In light of this property, the paper re-configures Jones’s model. The second issue addresses forward P/E-multiple dependence on future growth in expected eps. It is shown that the textbook Gordon-Williams 1/(r-g) approach makes no sense. An alternative modeling views growth as information – not a parameter like Gordon-Williams. Thus, the P/E-multiple is shown to depend on the growth in expected earnings, Y2 vs. Y1. A similar g-parameter dependency is noted in the residual income model and the so-called OJ earnings growth model; both include a 1/(r-g) type of multiplier. This is viewed as a model-deficiency, that is, a ‘mistake’.

Keywords:

• Equity valuation
• growth
• accruals
• Jones model
• residual income valuation
• earnings management

Disclosure statement

No potential conflict of interest was reported by the author(s).