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The growth companies puzzle

While numerous empirical studies include proxies for growth opportunities in their analyses, there is limited evidence as to the validity of the various growth proxies used. Based on a sample of 1,942 firm years for listed UK companies over the period 1990 to 2004, we assess the performance of eight growth opportunities measures. Our results show that none of the measures has any success in predicting EPS growth. We term this the ‘growth companies puzzle’. The second part of the paper looks at the ability of growth opportunity measures to predict growth in sales, assets and book equity. All the growth measures show some ability to predict growth in these dimensions. However, Tobin’s Q (a widely used measure in the empirical literature) performs very poorly, while dividend based measures generally perform best. Growth companies do grow, but they do not grow in the key dimension (earnings) theory predicts. We suggest that a possible resolution of the puzzle may lie in the time-series behaviour of company earnings. Where profits are high, new capacity enters the market and reduces profitability. The profitability of new investment must therefore be balanced against the falling profitability of the original investments.