With artificial intelligence on the horizon as this book was written, we are keen to see how it aids value investing. We are a little reserved about it, for we question whether the good thinking required in business analysis and accounting analysis can be gained by a machine. But the jury is out.
Here is a question asked of ChatGPT in May 2024:
Let’s say hypothetically that ROE is 12% and the cost of equity is 9%. The difference is 3%. Let’s say the retention rate is 75%. 75% of 3% is 2.25%. Is 2.25% the sustainable growth rate of residual income?
Here is ChatGPT’s answer:
In the scenario you’ve described, the 2.25% is not the Sustainable Growth Rate (SGR) of residual income; rather, it’s the growth rate of the residual income itself. Here’s why:
The SGR is calculated using the formula: SGR=ROE × Retention Ratio
In your hypothetical case:
The ROE is 12%. The Retention Ratio is 75%.
So the SGR would be:
SGR = 12%×75% = 9%
The SGR indicates how much a company can grow sustainably without needing additional financing, assuming it reinvests its retained earnings at the current ROE.
Now, the 3% you’ve calculated is the excess return over the cost of equity, which represents the additional value created over and above the required return by shareholders. When you multiply this excess return by the retention ratio (75%), you get 2.25%, which represents the growth rate of the residual income, not the SGR.
The growth rate of residual income is essentially how much the residual income can grow each year, given the company’s ability to generate earnings above the cost of equity and the proportion of those earnings it chooses to retain and reinvest. So in your example, the residual income can grow at a rate of 2.25% per year, based on the excess return and the retention ratio.
Does ChatGPT have it right?
ChatGPT does quite a good job but not get it quite right. Retention does not necessarily add to residual earnings. It’s a question of how the retained earnings are invested. If, for example, the firm can only find investments to earn at the cost of capital, there is no growth in residual income (value added). The answer assumes that reinvestment is at the same ROE as is currently being earned. Further, for a growth rate for the future, it assumes that the firm will perpetually earn at the current ROE and that all the firm must do is retain so it will automatically grow residual earnings.
To be fair, ChatGDP states this assumption…“assuming it reinvests its retained earnings at the current ROE.” But this a very special case which almost never applies; ROE changes over time; often new investment earns at a lower rate than existing investment. The appropriate analysis involves a forecast of investment opportunities and the ROE that will be earned from that investment. It is a common mistake to assume ROE is a permanent feature of firms.