Determining the Expected Growth Rate for Estimating a Firm's Earnings Multiplier

A

Higher expected growth rates would indicate that a firm should have a higher multiple than its industry and the market.

In estimating a firm's earnings multiplier, the expected growth rate is determined by the firm's retention rate and expected return on equity (ROE). Therefore, the correct answer is A. retention rate and expected return on equity.

The earnings multiplier, also known as the price-to-earnings (P/E) ratio, is a valuation metric used to assess the relative value of a company's stock. It is calculated by dividing the market price per share by the earnings per share (EPS) of the company. The earnings multiplier reflects the market's expectations for the future earnings growth of the firm.

The expected growth rate used in the estimation of the earnings multiplier is dependent on two factors: the firm's retention rate and expected return on equity (ROE).

1. Retention rate: The retention rate is the proportion of earnings that the company reinvests back into the business rather than distributing them to shareholders as dividends. A higher retention rate implies that the company is retaining more of its earnings to fund future growth opportunities. This reinvestment can lead to higher earnings growth in the future, which is reflected in a higher expected growth rate.

2. Expected return on equity (ROE): ROE is a measure of a firm's profitability, indicating how efficiently it generates profits from shareholders' equity. It is calculated by dividing net income by shareholders' equity. A higher ROE suggests that the company is generating more profits relative to the equity invested. A higher expected return on equity indicates the potential for higher future earnings growth, which influences the expected growth rate.

Combining these factors, a higher retention rate and expected return on equity indicate that the firm is reinvesting more profits into the business and generating higher returns, respectively. These factors contribute to the expectation of higher future earnings growth, leading to a higher estimated growth rate and, consequently, a higher earnings multiplier.

To summarize, the expected growth rate used in estimating a firm's earnings multiplier is determined by the firm's retention rate and expected return on equity (ROE). A higher retention rate and higher expected ROE indicate the potential for greater future earnings growth, resulting in a higher estimated growth rate and earnings multiplier.