In recent articles, we have looked at various ratios that value investors and analysts use to measure the performance of companies. We have looked at measures of liquidity, efficiency and profitability. Today, I want to focus specifically on sustainable growth rate. This is the rate of growth that a business can maintain without having to issue more equity or take on more debt. Growth, in this case, means an increase in the assets that a company has.
What is it?
How does a business grow? There are many options. For example, it can sell more common stock, or take out a loan at a bank to fund various projects. However, this is not "sustainable" growth, in the sense that it does not come from within the company's existing value. At its core, the sustainable growth rate of a company is related to the income that the business earns and the percentage of that income that is fed back into the business.
There are two components of the sustainable growth rate calculation. The first is the return on equity (a measure of income earned), which is calculated as net income divided by equity. The second is the retention rate (a measure of how much income is reinvested), which is calculated as [1 - the dividend payout ratio]. The dividend payout ratio is just the total cost of dividends paid divided by net income. If a company has a net income of $10 million, and returns $4 million to shareholders through dividends, then its dividend payout ratio is 4/10 = 0.4, and its retention rate is 1 - 0.4 = 0.6.
If the same company has a return on equity (ROE) of 15% and a retention rate of 0.6, then some simple arithmetic gives you a sustainable growth rate of 9% (15% x 0.6).
What is it for?
Investors need to have a baseline sustainable growth rate to compare to the actual rate of earnings growth. If the actual rate of earnings growth is significantly higher than the sustainable rate, then that means that money is coming from outside the company. This can signify that the business may be taking on more debt, or diluting existing shareholder equity.
Conversely, an actual growth rate that is less than the sustainable rate is an indication that there is room for the business to grow more. This is not necessarily a bad thing, as businesses will tend to have different growth rates at different points in their life cycles. A high sustainable growth rate indicates that the company is reinvesting a lot of its earnings, which could lead to difficulty in servicing interest on debt. Potential lenders use sustainable growth rate as a measure of credit risk.
However, a sustainable growth rate can also be an indication that the company enjoys high margins, and is managing its inventory and cash effectively. As with all financial metrics and ratios, sustainable growth rate is only really useful when put into the context of industry averages and when the analyst can break down the formula to determine which of its components are contributing to the end result.
Read more here:
- Warren Buffett: Investing in Turnarounds Is Difficult
- How to Analyze a Company’s Operating Performance: Profitability Ratios
- How to Analyze a Company's Operating Performance: Efficiency Ratios
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