Question

2. Does the value of a firm necessarily increase if the earnings growth of the firm increases?

Answer 1

Companies which shows increase in profit or earnings not necessarily increase in value. Increase in value of a firm is determined by the actual transfer of this increase to shareholders. Company can increase their earnings by raising more funds which result in more sales and more profit. But this doesnt means the individual shareholders are benefited. If a company increase its earnings by raising debts, and if the increasing in earnings is not proportionate to the debt raised, the debt holders will eat up most of the increase in earnings. Similarly if a company increased its earnings by raising equity and the net earnings received per share has not increased, the value of the firm will not be increasing.

The first thing we need to check to understand if a firms value will increase due to increased earnings is to check the EPS of the share. ie If Earnings per share has increased, it is a positive sign that the value of the firm will increase since it signals the increased earnings can be delivered to share holders. Moreover we need to check the exact cash flows of the firm to estimate the better estimate of the firm value. Earnings or Profit of a firm includes several non cash expenses and revenues which might not interest shareholders. Whereas shareholders are interested in actual cash flow to the firm through its operations and if actual cash flows is consistently increasing , it will definitely increase the value of a firm.