Price of Growth

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When you perform an absolute valuation, the most uncertain and sensitive input is usually the growth rate.

This is why much of the effort when building a DCF/DDM should be on estimating growth. It also helps to forecast growth from fundamentals (not just historical trends or analyst estimates) and perform scenario and sensitivity analysis.

But what if you could reduce your reliance on speculative growth assumptions altogether?

This is what Stephen Penman teaches in his 2025 book “Financial Statement Analysis for Value Investing.” Rather than speculating about long-term growth, he anchors valuations on what can actually be measured: book value and near-term earnings forecasts.

Penman's approach separates what you know from what you're guessing, giving you a concrete way to challenge whether the market's expectations make sense.

Below, we'll explain the residual earnings model, walk through a valuation of Ferrari (RACE), and isolate what the market is paying for growth.

Absolute valuation methods require investors to forecast free cash flows (w/DCF) or dividends (w/DDM) far into the future.

The problem is that these forecasts become increasingly speculative as you extend the timeline, and small changes in terminal growth can shift your implied valuation significantly.

Penman’s approach is to start with what you already know from the balance sheet: book value (aka shareholders’ equity). This represents the accountant’s measure of what the business is worth based on assets minus liabilities (the accounting equation).

Then ask: Will the company add value beyond what’s already captured in book value?

If a company earns returns above what shareholders require, it creates value. If it earns below that threshold, it destroys value.

This produces the concept of residual earnings (aka residual income). The premise is that shareholders have capital invested in the business, and they expect some minimum return on that capital. Earnings above that minimum are the “residual” that creates additional value.

Here’s the residual earnings formula:

where:

Suppose a company has $100M in book value and earns $15M in net income. If shareholders require an 8% return, they expect $8M (8% × $100M).

The company earns $15M, so residual earnings equal $7M ($15M − $8M). That $7M represents value creation beyond what shareholders demanded.

Now consider the opposite case. If that same company earned only $5M, residual earnings would be negative $3M ($5M − $8M). The company isn't covering shareholders' minimum expectations, so it destroys value.

Under clean surplus accounting (where all changes to book value flow through earnings or dividends), the residual earnings model yields the same value as the dividend discount model (DDM) mathematically:

This matters because the DDM requires forecasting dividends, which are management decisions that don't reflect underlying value creation. A company can change its dividend policy without changing its fundamental value.

Residual earnings sidesteps this issue by focusing on earnings power rather than cash distributions.

The residual earnings concept translates into a valuation model. Start with book value, then add the present value of future residual earnings:

where:

In practice, you can only forecast residual earnings for a couple years with confidence. Beyond that, you need some assumption about long-term growth. This produces the full model with a continuing value:

where:

Continuing value captures everything beyond your forecast horizon. This is where speculation enters.

But unlike DCF/DDM, where nearly all the value sits in the terminal value calculation, residual earnings valuation typically places more value in book value and near-term forecasts.

Since residual earnings equals net income minus a charge on book value, it's positive when ROE exceeds the required return and negative when it falls short. Three principles follow that always hold true:

These relationships create mispricing signals. A stock trading at P/B < 1 that you forecast to earn above the required return is a potential buy. A stock at P/B > 1 that you expect to earn below the required return is a potential sell.

Now that you understand the residual earnings model and how P/B ratios connect to ROE, let's apply this to a real company.

Penman uses Netflix (NFLX) as his example, but to provide something more recent (and not copy), we'll use Ferrari (RACE) instead.

Ferrari, the Italian luxury automaker, has long traded at valuations more comparable to Hermès than traditional carmakers. But in October 2025, the stock suffered its worst single-day decline since its 2016 IPO, dropping 16% after management released financial guidance at their Capital Markets Day that disappointed investors:

As you can see, the company projected ~5% annual revenue growth and adjusted diluted EPS of ≥€11.50 by 2030. While the targets show continued profitability expansion, the growth rate was far below what the market had priced in for a company trading at luxury multiples.

Currently, the stock is trading at $376.08, down from YTD highs of $517.65 (back in July 2025):

Given this context, let's value Ferrari using Penman's approach. The end goal is to determine whether the company's current price makes sense.

To calculate Ferrari’s residual earnings, find/calculate the company's earnings per share (EPS), dividends per share (DPS), book value per share (BPS), and return on equity (ROE) for the latest fiscal year.

Then, based on your understanding of the business or analyst estimates, input EPS and DPS estimates for the next two years. We used Fiscal.ai to pull these estimates along with three years of actuals for a more complete picture.

The only remaining input is the required return. There are various approaches to estimate this, but since it's not our focus here, we'll simply use 10% (roughly market average).

From there, calculate forward BPS, ROE, and residual earnings (RE) for each forecast year. Here are the calculations for 2025:

Putting this together in a model:

Before separating what we know from speculation, it helps to see where the valuation lands at a benchmark growth rate.

According to Penman, residual earnings growth tends to converge toward the ~4% US GDP growth rate over the long run, so we'll use that:

where:

Our model breaks up the calculation as well:

At a 4% perpetual growth rate, the model suggests Ferrari is worth $138.59/share, far below its current price of $376.08.

This tells us the market is pricing in growth well above the GDP benchmark. But rather than guessing what growth rate justifies the price, Penman's approach is to separate what we can account for from what remains speculative.

So far we've used the residual earnings model the same way most investors use DCF: plug in assumptions and calculate a value. But Penman argues this misses the point.

The valuation model doesn't need to produce a single intrinsic value. Instead, it can separate what you can account for from what remains speculative. Penman elaborates:

Following this approach, don't enter any growth rate into the model. Instead, calculate the no-growth value, which captures only what the accounting can support. This means assuming residual earnings stay flat after your forecast horizon rather than growing:

where:

For Ferrari, divide year two residual earnings by the 10% required return (assuming zero growth beyond that point):

Then complete the full no-growth valuation:

Now compare this to the market price. Ferrari trades at $376.08, while the no-growth accounting value is $93.84. The difference represents the price the market is placing on growth: $282.24 ($376.08 − $93.84).

Put differently, the market price decomposes into three components: (1) book value of $20.37, (2) value from short-term accounting (no-growth value less book value) of $73.46, and (3) value from long-term growth of $282.24.

Here’s the visual breakdown:

This changes the valuation problem entirely. Rather than challenging the market price directly, you now have the market's valuation of growth to challenge.

The question becomes: Is paying $282.24/share for Ferrari's future growth reasonable given the company's competitive position and management's guidance?

If you feel that a forecast two years ahead is too speculative, you can anchor on book value and a forecast for only the forward year:

For a no-growth value using only one year of forecasts, set speculative value to zero:

This is more conservative than the two-year anchor of $93.84. The market price of $376.08 now implies $286.08 in speculative value ($376.08 − $90.00) rather than $282.24.

The difference is small here, but for companies with more volatile earnings forecasts, anchoring on just one year may provide a cleaner separation between what you know and what you're guessing.

You can go even further. If you're uncertain about earnings one year ahead, you can use currently observed residual earnings (what you already know) instead of forward residual earnings.

We've already calculated the residual earnings for Ferrari in FY2024, which is $6.73 ($8.77 − (0.10 × $20.37)). So just solve for present value:

This excludes any speculation in the forward earnings forecast entirely. The tradeoff is that you're ignoring analyst estimates (or your own) that may contain useful information about where earnings are heading.

Our model features the complete comparison:

A dollar value for growth doesn't give you a clear benchmark to challenge. But you can go further by reverse engineering the exact growth rate implied in the market price (similar to a reverse DCF).

Using Excel's Goal Seek function or trial and error, you can find the growth rate that produces the market price. For Ferrari at $376.08, the implied growth rate is 8.1%:

For context, when Ferrari traded at its YTD high of $517.65 back in July 2025, the implied growth rate was 8.6%. The recent selloff only reduced growth expectations from 8.6% to 8.1%, a modest decline despite the stock dropping ~27% from YTD highs.

Growth rates typically start high and fade toward the ~4% GDP rate as competition erodes excess returns.

If you examine Ferrari’s historical and forecasted residual earnings growth, growth has already decelerated sharply from 29.4% to the 3-6% range:

Yet the market is pricing in 8.1% perpetual growth, which exceeds even the most optimistic near-term forecast.

This means investors expect Ferrari to either (1) reaccelerate growth above current forecasts or (2) sustain elevated growth for an unusually long period before fading to 4%.

Both assumptions are aggressive given management's conservative guidance and the deceleration already underway:

Your view on Ferrari's competitive durability determines which side of this trade you're on.

This analysis connects to the idea of competitive advantage period (CAP), which measures how long a firm can generate excess returns. For a given starting growth rate, the higher the implied market price, the longer the CAP embedded in that price.

Ferrari's FY2024 ROE of 46.1% (compared to the 10% required return) means the company creates substantial residual earnings even with modest growth. But at a P/B of 18.5x, much of the stock's value depends on those excess returns persisting far into the future.

To put this in perspective, a P/B of 1.0x implies ROE equals the required return (no excess value created). Ferrari's 18.5x multiple implies the market expects its high ROE to persist for many years. If ROE compresses or the advantage period is shorter than expected, the stock is overpriced.

Building on the relationship between price and implied growth, here's how Ferrari's implied growth looks at different prices:

And here’s a table that breaks this down further:

The "Market's Price for Growth" column shows what percentage of the total market price comes from growth expectations rather than accounting value.

At $376.08, roughly 75% of Ferrari's price comes from growth speculation. Only about a quarter is supported by book value and near-term earnings.

Even at $300/share, the implied growth rate would still be 7.5%, well above both the 4% GDP benchmark and the 3-6% near-term forecasts.

At these prices, you're paying a premium for growth no matter where you enter.

Benjamin Graham characterized Mr. Market as a moody fellow, swinging between speculative optimism and fearful pessimism. The implied growth rate gives you a way to evaluate his mood.

This is what Penman means by "think about the person asking you to trade." You're not trying to calculate a precise intrinsic value. You're reverse engineering what the market assumes, then deciding if you agree.

For Ferrari, the market prices in 8.1% average residual earnings growth while near-term forecasts sit at 3-6%. You don't need to know what Ferrari is worth. You need a view on whether 8.1% sustained growth is realistic given management's guidance and the deceleration already underway.

According to Penman, the primary risk of investing is paying too much. This approach quantifies exactly how much you're paying for growth, so you can decide which side of the trade you want to be on.

Active investors can use this to screen for mispriced stocks where growth expectations look unreasonable. Defensive investors can use it to identify overpriced stocks to avoid, even within a broad index.