Growth is the key input in every valuation and there are three sources for growth rates. One is the past, though both estimating and using historical growth rates can be difficult for most firms with their volatile and sometimes negative earnings. The second is analyst estimates of growth. Though analysts may be privy to information that is not available to the rest of the market, this information does not result in growth rates that are superior to historical growth estimates. Furthermore, the analyst emphasis on earnings per share growth can be a problem when forecasting operating income. The third and soundest way of estimating growth is to base it on a firm's fundamentals.

The relationship of growth to fundamentals will depend upon what growth rate we are estimating. To estimate growth in earnings per share, we looked at return on equity and retention ratios. To estimate growth in net income, we replaced the retention ratio with the equity reinvestment rate. To evaluate growth in operating income, we used return on capital and reinvestment rate. While the details vary from approach to approach, there are some common themes that emerge from these approaches. The first is that growth and reinvestment are linked and estimates of one have to be lined with estimates of the other. Firms that want to grow at high rates over long periods have to reinvest to create that growth. The second is that the quality of growth can vary widely across firms and that the best measure of the quality of growth is the returns earned on investments. Firms that earn higher returns on equity and capital will not only generate higher growth but that growth will add more to their value.

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