Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm9/susgrowt.doc

Text File | 1991-07-11 | 9.9 KB | 208 lines

Determining a Sustainable Growth Rate
By Fred Shipley
Computerized Investing, September/October 1990

In the series of articles covering stock valuation models
(Computerized Investing, September 1987 through July/August
1988) we paid particular attention to growth as one of the
primary determinants of stock value. The article by John
Bajkowski on the DuPont method of financial statement
analysis (Computerized Investing, January/February 1990),
focused on the breakdown of an income statement and balance
sheet to examine the determinants of return on equity (ROE).
In this article, I will integrate these two analytical
methods to examine what is critical in the relationships
between growth (in revenues, earnings and dividends) and
profit margin, turnover and leverage. This analysis will
allow you to see how a company is generating growth and to
evaluate whether that growth is sustainable over the long
run.

Financial analysts have long known that growth is critical in
the valuation process, whether one values a company on the
basis of its cash flows, its earnings or its dividends. In
the dividend valuation model, the importance of growth is
quite obvious, since growth appears directly in the
denominator of the value equation, as seen in the following
equation:

P0 = D1/(r-g)

where: D1 is the anticipated annual dividend for the next
year, r is the required rate of return on the stock,
g is the anticipated rate of dividend growth, and P0 is the
estimated value.

You will note that the rate of growth in this valuation
technique is explicitly the rate of dividend growth.
Analysts, however, recognize that dividend growth is tied to
growth in sales, earnings, and perhaps most importantly, cash
flows. All of these income statement items are related, and
sometimes analysts make their lives easier by assuming a
constant relationship among all these variables.

As an example, for a given rate of growth in sales, if the
company's profit margin (net income divided by sales) remains
the same, then its earnings must grow at the same rate as its
sales. Continuing down the income statement, if the company's
dividend payout ratio (dividends paid divided by net income)
does not change, then the rate of dividend growth equals the
rate of earnings growth. Since the rate of earnings growth
equals the rate of sales growth, the rate of dividend growth
also equals the rate of growth in sales.

Of course these relationships do change over time, even when
a company has a long-term target rate of growth for sales, an
estimated long-run profitability goal and a target payout
ratio. Thus, an investor must be able to examine how these
variables are related, and see how changes in the growth
rates of earnings and dividends are affected by changes in
profit margin and payout ratio.

One way that analysts evaluate growth is to estimate what is
called sustainable growth. The intuition behind sustainable
growth is that it measures the rate of growth a firm can
maintain without resorting to outside financing or changing
leverage. In other words, growth is sustainable if the
company can maintain that growth with its own internal
resources and without changing its financial risk.

The easiest case to examine is that of a company that is 100%
equity financed. In order to grow, this company must reinvest
earnings. For sales to grow, the company must have more
inventory; in order to buy more inventory the company must
have financing. Since the financing comes from equity, the
company must reinvest earnings. This is a particularly simple
(and extreme) case, but it emphasizes the importance of
reinvesting earnings to maintain growth. Indeed, most
companies, especially smaller ones, emphatically state that
they must reinvest earnings to maintain their growth.

There is another issue here--the cost of obtaining financing
from external sources. Again, this is most important for
smaller companies. Any time a company seeks financing from an
outsider--whether it is a bank, a supplier, a venture
capitalist, relatives of the major stockholder, or a loan
shark--there is a fee involved. In general, fees for debt are
less than the fees associated with the sale of equity, and
the cost of short-term debt is usually less than the cost of
long-term debt (though the latter is not always true).
Moreover, the cost of small amounts of financing is typically
much higher on a percentage basis than the cost of larger
amounts.

The costs of selling an issue of stock or obtaining a loan
are sufficient to provide a strong incentive for a company to
finance growth internally, if possible. For that reason, most
companies come to the market for new financing only on a
periodic basis, when they have a major new project or when
they judge the market to be propitious for a new issue.

Leverage and Risk

The final issue to be considered in connection with internal
versus outside financing is the issue of leverage and risk.
Leverage refers to the magnification of a change in sales on
the bottom line--net income (or earnings). Financial analysts
talk about two kinds of leverage, operating leverage and
financial leverage. Operating leverage refers to increasing
the proportion of operating costs that are fixed, relative to
those that are variable.

We will not concern ourselves further with operating
leverage; it is sufficient for our purposes to deal with
financial leverage. Financial leverage works by substituting
the fixed (interest) cost of debt for the variable (dividend
payment) cost of equity. For our leverage calculation (total
assets divided by equity), a higher number indicates greater
financial leverage. When a company is operating profitably
and generating large cash flows, leverage is advantageous.
With the fixed interest cost of debt, there is more cash
available for reinvestment and dividend payments. But
leverage is a two-edged sword, as many companies have
discovered (and continue to rediscover), increasing the
variability of earnings. When cash flow decreases, interest
payments must still be made--unless the company's bankers are
very generous--leaving less funds for the stockholders.

Thus the use of financial leverage affects the risk stock-
holders face. The more leverage the company has, the greater
the risk to the stockholders. This risk is, of course, offset
by the (potentially) greater returns. Changing leverage is
only one of the ways a company can affect the returns to its
stockholders. When we talk about sustainable growth, we
assume that leverage does not change. With the DuPont
analysis, we can see whether this is valid.

Sustainable Growth

Formally, sustainable growth (gsus) is defined as a company's
return on equity (ROE) times its earnings retention ratio
(b--invested earnings divided by total earnings). That is,
gsus = ROE x b

We gave the rationale for this definition earlier: That a
company can expand using its own internal resources, by
reinvesting and generating a return on that reinvestment.

As defined, sustainable growth can be measured on an annual
basis. Every year we can examine a company's annual report,
determine their realized return on equity for the year and
the proportion of earnings paid out to the stockholders.
Clearly both the return a company earns and the proportion of
earnings it may reinvest can vary from year to year. Both
these factors depend on market conditions, the company's
competitive situation, the availability of new (and
presumably profitable) investment opportunities and long-term
strategic plans. We want to examine the components of return
on equity to see whether there are strategic changes
occurring that will affect our assessment of long-term
sustainable growth.

Return on equity has varied from just under 13% (in 1983) to
just over 20% (1988 and 1989). The lower numbers were
primarily due to low profit margins in the early 1980s.
Considering the economic climate then--high inflation and
slow growth-- this is not surprising. In the mid-1980s (1986
to 1988), the company was able to rebuild profit margins as
well as increase total asset turnover, thus making more
effective use of their plant and equipment. This was combined
with an increase in leverage to substantially increase return
on equity. The 1990 projections show a reduction of profit
margin and slightly lower asset turnover, which is offset by
an increase in leverage. These combined effects led to a 12%
drop in the rate of sustainable growth.

The average sustainable growth rate of 9.15% falls around the
middle of the range of growth rates calculated from our stock
valuation spreadsheet.

Setting Up the Spreadsheet

The figures show the spreadsheet set up as a modification of
the basic stock valuation template. This is done to show the
comparative growth rates of sales, dividends, earnings, cash
flow and book value, as well as the factors affecting
sustainable growth. You can either add the additional
necessary data to your stock valuation spreadsheet, or create
a modified spreadsheet for analyzing sustainable growth
separately.

To determine sustainable growth we need certain balance sheet
data that are not readily available from the Value Line
Investment Survey, the source of our original data. The
balance sheet data are easily obtained from the Standard &
Poor's Stock Reports. In addition, we need the number of
shares outstanding to determine total assets on a per share
basis, consistent with our other figures. Value Line reports
shares outstanding.

Once you have entered this data, you create a column with
total assets per share (column F), then columns with total
asset turnover (column O), leverage--or total assets divided
by equity--(column P), earnings retention ratio (column R),
return on equity--just a check figure--(column Q), and
finally, sustainable growth (column S).

(c) Copyright 1991 by the
American Association of Individual Investors