Fundamentals and Purpose

The Earnings Growth and Exit Multiple model is a projective valuation technique that seeks to answer a pragmatic question: "How much will this stock be worth in year X if the company meets its growth targets and the market values it rationally?".

Unlike present value models (like DCF), which try to bring all future flows to today to find an exact "Intrinsic Value", this model focuses on calculating a Future Target Price. It is based on the mechanical reality of the stock market: the price of a stock in the long term is the product of its earnings per share (EPS) and the multiple investors are willing to pay for them (P/E Ratio).

In advanced academic circles and among institutional investors, this approach is sometimes called "Delta of the Delta" Valuation. This name, derived from differential calculus, refers to the sensitivity of the price not only to the change in earnings (first delta), but to the change in the rate of change of the valuation (second delta).

The purpose of the model is to determine the Expected Rate of Return (CAGR). If the stock promises a 15% annual compounded return under conservative assumptions, it is considered an attractive investment, regardless of what a theoretical DCF model says.

The "Delta of the Delta" Philosophy: The Two Price Engines

To understand why this model is superior to a simple linear projection, we must break down the components of a stock's total return, as detailed in the specialized literature on "Delta of the Delta":

The change in price (Return) comes from three sources:

1. Earnings Growth (Delta 1): If the company sells more and earns more, the stock goes up.
2. Expansion/Contraction of the Multiple (Delta 2): This is where the "Delta of the Delta" concept resides. The P/E multiple is not static; it is a reflection of expectations of future growth and business quality.
3. Dividends: The cash return to the shareholder.

The "Twin Engines" Effect: The model seeks to identify the ideal scenario where both deltas are positive. If a company accelerates its growth from 10% to 20%, not only do its earnings increase (Delta 1), but the market, excited, revalues the stock by raising the P/E from 15x to 25x (Delta 2). This generates exponential price growth.

Conversely, the model serves as a risk warning: if growth slows down, the market punishes the stock doubly (lower earnings and lower multiple), causing catastrophic falls.

Components and Calculation Mechanics

The model is executed in a logical sequence of four steps.

1. EPS Projection (Earnings Per Share)

The compound annual growth rate (CAGR) of earnings for the next 5 to 10 years must be estimated.

2. Determination of the Exit Multiple

This is the art within the science. We must decide at what P/E the company will trade in year 10. We cannot blindly use the current P/E. For precision, we use three triangulations:

• A. The Historical Approach: We observe the mean and median P/E of the last 10 years (as in regression to the mean tables). If the historical average is 18x, it is imprudent to project an exit at 30x.
• B. Business Quality (ROE and ROIC): There is a direct correlation: companies with high Return on Capital (ROIC) deserve higher P/Es because each retained dollar generates more value.
  • ROIC > 20%: High multiples (20x - 30x).
  • ROIC < 10%: Low multiples (8x - 12x).
• C. The Terminal Growth Rule: At the end of the projection period (year 10), the company will likely have matured. If it is expected to then grow at only 5%, its P/E should compress towards 12x-15x, regardless of it trading at 50x today.

3. Calculation of the Future Target Price

We multiply the projected EPS by the selected Exit Multiple.

4. Expected Return (Implied Discount Rate)

Finally, we compare the Future Price (plus accumulated dividends) with the Current Price to obtain the CAGR.

Detailed Practical Case: "Innovation Inc."

Suppose we analyze Innovation Inc., a growing technology company.

Current Data:

• Current Price: $100
• EPS (TTM): $4.00
• Current P/E: 25x
• ROIC: 22% (Excellent quality)

Step 1: Earnings Projection (10-year horizon)

We estimate the company will grow 12% annually over the next decade.

Step 2: Exit Multiple Selection

Here we apply judgment.

• Current P/E: 25x (High, reflects high growth).
• History: The 10-year average has been 20x.
• Future: In 10 years, the company will be more mature and grow slower. We assume multiple contraction (Delta 2 negative).
• Decision: We assign an Exit P/E of 18x. (Conservative, aligned with moderate terminal growth and high ROIC).

Step 3: Target Price (Year 10)

Step 4: Return Calculation (CAGR)

Is it a good investment to buy today at $100 to sell in 10 years at $223.56?

Decision: An annual return of 8.38% may be insufficient if we aim to beat the index (which historically yields 9-10%) or if our required rate is 15%. Even though the company will triple its earnings, the multiple contraction (from 25x to 18x) "eats" much of the profitability. This is "Delta of the Delta" working against us. The investor should wait for the price to drop to $70 to get a double-digit return.

Intrinsic Value vs. Target Price: A Crucial Distinction

It is fundamental that encyclopedia readers distinguish these two often-confused concepts in this model:

• Intrinsic Value: A philosophical and mathematical figure derived from discounted cash flows (DCF). It represents what the asset is truly worth, regardless of market opinion. It is static at a given moment.
• Target Price: A prediction of market psychology. It represents what we believe someone will pay for the asset in the future. This model calculates the Target Price.

The "Exit Multiple" model assumes the market will be, at least, reasonably efficient in year 10. If the market enters a depression in year 10 and multiples collapse irrationally, our Target Price won't be met, even though the company's Intrinsic Value remains intact.

Methodological Criticism and Risks

Although it is Wall Street's favorite model for its simplicity and focus on price, it has significant risks that the investor must manage.

1. The Danger of Linear Extrapolation The most common error is assuming past growth will persist. As the "Delta of the Delta" concept warns, changes in the growth rate are what move prices. Projecting 15% growth forever in a company slowing to 10% will result in massively inflated valuations.

2. Exit Multiple Sensitivity A small change in the exit P/E drastically alters the return.

• In the previous example, if we change the Exit P/E from 18x to 22x, the final price jumps from $223 to $273. This subjectivity allows analysts to "manipulate" the model to justify any current purchase price. To mitigate this, always use a multiple range (Pessimistic, Base, and Optimistic Scenario).

3. Ignoring Capital Structure (Debt) This model is based on P/E, which looks at equity value. If a company takes on massive debt to buy back shares and artificially inflate EPS, the model may give a buy signal while bankruptcy risk increases. It must always be verified that EPS growth is accompanied by a healthy ROIC and not just financial engineering.

The Final Verdict: When to Use It?

The Earnings Growth and Exit Multiple model is ideal for:

• Growth Companies and GARP (Growth at a Reasonable Price): Where most of the return will come from capital appreciation and not dividends.
• Investors with a Defined Time Horizon: If you know you want to hold the stock for 10 years, this model tells you exactly what needs to happen to achieve your return objective.
• Scenario Evaluation: It allows "What if?" questions. What if growth falls to 5%? Do I still make money? If the answer is yes, you have a Margin of Safety.

In summary, this model reminds us that, as investors, we own a future stream of earnings, but our final outcome depends on how much the market is willing to pay for that stream on the day we decide to sell.