What Does High Asset Growth Say About a Company's Expected Return?
For nearly 40 years, research at Dimensional has focused on advancing our understanding of what drives differences in expected returns among securities. A recent study by our Research team into the behavior of firms with high investment suggests new ways to potentially enhance expected returns for equity investors.
Our research is motivated by valuation theory, which provides a useful framework for analyzing the drivers of expected returns. It says that expected returns are driven by the prices investors pay and the cash flows they expect to receive. Expected future cash flows are related to the expected future profits of a company. However, not all profits are returned to shareholders because companies may make investments. Therefore, expected investment lowers expected future cash flows to shareholders, all else equal.
How can we measure and quantify firm investment? There are three ways a firm can raise capital to invest: equity issuance, debt issuance, and growth in retained earnings. Asset growth aggregates financing from all three methods. Equity issuance and growth in retained earnings both lead to an increase in the book equity of a firm and, as a result, to an increase in total assets. Debt issuance leads to an increase in the liabilities of a firm and consequently also to an increase in its total assets. Thus, we can focus on asset growth as a broad measure of investment to examine the relation between investment and expected returns.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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