Estimating Earnings Growth From Fundamentals

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Many investors rely on historical growth trends or Wall Street analyst forecasts to estimate future earnings. But these methods often ignore the underlying business factors that actually drive company growth.

In this post, we’ll explain how Aswath Damodaran connects growth directly to company fundamentals—drawn from his 2025 book “Investment Valuation” (4th edition).

This will show you how company decisions about reinvestment, debt, and efficiency directly determine earnings growth, creating a more reliable forecasting approach.

Growth in earnings per share (EPS) tells us how quickly a company's profits are increasing for each share of stock.

Two main factors determine how fast a company's EPS will grow:

The expected growth rate in EPS can be calculated using this formula:

where:

Example #1 - Growth in EPS

Let’s compare three different automobile manufacturers to illustrate the expected EPS growth rate calculation:

As you can see, companies that held onto more profits and earned better returns on their investments showed stronger expected EPS growth rates.

When we look at EPS, we're only seeing part of the growth story. A company can grow its net income in ways that don't show up in EPS growth.

For example, a company might issue new shares to raise money for projects that increase total profits, even while EPS stays flat because the profit is now spread across more shares.

Therefore, we should evaluate how much a company is actually investing in growth (equity reinvestment rate), not just how much profit it keeps (retention ratio):

where:

Using this rate with ROE, we can calculate the expected growth in net income:

A key difference from the retention ratio is that the equity reinvestment rate can exceed 100% when companies raise new equity to fund major expansions. This happens when a business invests more in growth than what it generates in current profits.

Example #2 - Growth in Net Income

Let’s compare the same automobile manufacturers using the equity reinvestment approach.

First, we calculate the equity reinvested for each company (Table 1). Then, we calculate the equity reinvestment rate and the expected growth in net income (Table 2):

This analysis reveals a different picture than our EPS approach. Tesla shows 8.2% growth, lower than the 9.6% predicted by the retention ratio method. GM and Thor show large negative growth rates of -132.6% and -22.0%, respectively.

These negative equity reinvestment rates indicate the companies are taking out more capital than they're investing. This happens when companies reduce inventory, collect receivables faster, pay down debt, or let depreciation exceed new investments.

While this method shows what companies are actually doing with their capital, these figures can be volatile. For more reliable results, using 3-5 year averages for equity reinvestment rates is better than single-year data.

Example #3 - Growth in Net Income: 3-Year Avg Equity Reinvestment Rate

Here's a three-year average of equity reinvestment rates to smooth out annual fluctuations:

These three-year averages confirm Tesla as the only automaker with sustainable growth fundamentals.

Moreover, GM and Thor's consistent negative rates aren't just one-year anomalies but reflect deliberate strategies of capital distribution over business expansion.

To further refine our net income growth estimate, we can separate business operations from investment activities by removing non-operating income.

Step #1: Calculate operating income by removing interest from cash:

Step #2: Calculate ROE using only operating assets:

Step #3: Recalculate the equity reinvestment rate:

Step #4: Calculate the expected net income growth rate using the adjusted figures:

For most companies, making these adjustments will increase both the ROE and the equity reinvestment rate (because net income is reduced). This provides a clearer picture of growth from actual business activities rather than from cash holdings.

Example #4 - Growth in Net Income: Focus on Core Business Operations

Now, let's apply these steps to our automobile manufacturers.

We'll calculate non-cash net income by removing interest from cash holdings (Table 1), determine non-cash ROE using operational assets (Table 2), and compute expected growth in net income based on core operations (Table 3):

These adjustments show how large cash and equivalents can mask a company's true operating performance.

Tesla's ROE increases from 9.6% to 17.5% because removing their $36.5B cash reserves from the equity base reveals their car-making business generates better returns than overall numbers suggest.

GM's negative growth rate worsens from -132.6% to -199.7% when focusing only on operating income because removing their $967M in interest income reduces their earnings base while their negative reinvestment pattern remains unchanged.

Thor's expected decline changes slightly from -22.0% to -25.1% because of adjustments in their equity base calculations.

Both EPS and net income growth are affected by the return on equity (ROE) of a company. One major factor that affects ROE is how much debt the company uses.

When a company takes on debt to fund its projects, it can increase its ROE—but this only works if the company makes more money on its investments than it pays in interest. Here’s the formula that captures this relationship:

where:

Since ROE is based on accounting returns, all these values use book figures from the financial statements, not market values.

The second part of the formula (D/E × (ROIC - i × (1 - t))) will be positive when ROIC exceeds the after-tax interest cost, increasing ROE. If ROIC falls below the after-tax interest cost, this term becomes negative and reduces ROE.

Example #5 - Determinants of ROE

Let's examine how our three automobile companies achieve their returns (with marginal tax rate of 21%):

Comparing the components of ROE shows how differently these companies generate shareholder returns.

Tesla relies mainly on strong business operations (8.5% ROIC) with minimal debt leverage, making its 9.6% ROE more sustainable during economic challenges.

GM uses a different strategy - its core operations deliver only 4.1% returns, but by taking on substantial debt (200% D/E ratio) at very favorable interest rates (0.6%), it achieves a 9.2% ROE. While effective now, this approach creates risk if operating returns decline or interest rates increase.

Thor demonstrates how high borrowing costs can limit ROE. Despite decent operations (5.8% ROIC), its 7.5% interest rate largely offsets any benefit from its moderate debt level, resulting in just 6.5% ROE.

Overall, you should be wary of companies whose high ROE comes primarily from debt rather than operational strength. If business conditions deteriorate or interest costs rise, their returns can quickly collapse as the debt advantage reverses into a burden.

When looking at ROE, we need to understand that ROE calculations (net income / shareholders’ equity) measure the returns on all investments—both old and new projects. This gives us the average (aka aggregate) ROE.

For larger companies especially, average ROE may not change much even when new investments are performing poorly because older investments typically make up most of a company's assets and earnings.

For valuation purposes, what a company earns on its newest investments often tells us more about future growth. To measure this, we can calculate the marginal ROE:

Example #6 - Average vs. Marginal ROE

Let's use our Tesla example to demonstrate how to apply this concept. First, here's our aggregate ROE calculation in FY2024:

The marginal ROE for TSLA between FY2023 and FY2024 is calculated as follows:

Tesla's negative marginal ROE (-78.5%) against its 9.6% aggregate ROE reveals a concerning trend - recent investments aren't performing like established operations.

This suggests investors should expect lower future returns, probably below the current 9.6% ROE, highlighting why both metrics matter for accurate forecasting.

So far, we've assumed that a company's ROE stays the same over time. But what happens when ROE changes?

If a company improves its ROE, it creates additional growth beyond what we'd expect from the earnings growth formula. This additional growth can be calculated as:

Damodaran explains that this adjustment is added to the expected EPS growth rate equation (ROE × retention ratio). Alternatively, the same adjustment can be applied to the expected net income growth formula (equity reinvestment rate × ROE).

This additional growth, which Damodaran calls "efficiency-generated growth," comes from improving returns on existing investments—not from new ones (as discussed below).

Different Scenarios of ROE Change

The impact on growth depends on which investments see improved returns:

Understanding these different scenarios will help us evaluate whether a company is genuinely becoming more efficient or simply making different investment choices.

Example #7 - When ROE Changes

Let's apply this concept to Thor Industries. We know Thor has a 6.5% ROE and retains 61.5% of its earnings. Assume Thor improves its overall ROE to 8% next year.

The expected growth rate in EPS next year would be:

This shows Thor could see a 28.0% earnings growth, far above its normal rate, even without changing how much profit it keeps. After next year, growth would return to 4.9% (8.0% × 61.5%).

What if the ROE improvement affected only new investments but not existing ones?

When only new investments benefit from the higher ROE, there's no additional growth from existing assets. Therefore, Thor would see 4.9% expected EPS growth (8.0% × 61.5%).

What if the improvement happened only on existing assets? Then, the expected EPS growth rate next year can be calculated as:

In this scenario, Thor achieves 27.1% growth by improving only its existing assets, nearly matching the 28.0% from improving both existing and new assets.

This shows that making current operations more efficient delivers most of the benefit without needing to improve the returns on new investments.