Pagemaster Enterprises just reported earnings of $2 million. The firm plans to retain 40 percent of its earnings in all years going forward. We also could say that 60 percent of earnings will be paid out as dividends. The ratio of dividends to earnings is often called the payout ratio, so the payout ratio for Pagemaster is 60 percent. The historical return on equity (ROE) has been 16 percent, which is expected to continue into the future. How much will earnings grow over the coming year?

We first perform the calculation without reference to Equation 9.8. Then we use Equation 9.8 as a check.

Calculation without Reference to Equation 9.8 The firm will retain $800,000 (= .40 × $2 million ).

Assuming that historical ROE is an appropriate estimate for future returns, the anticipated increase in earnings is:

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g= 4 x.16 = .064, or 6.4%