You may forecast an earnings growth rate for the future.
There are a number of guidelines for this forecast.
One is called the Sustainable Growth Rate.
Sustainable growth rate is that rate at which the company can continue to grow, without having to borrow money or without having to issue new common stock.
This rate is a function of both Return on Equity [ROE] and the dividend payout ratio.
ROE is a measure of how well management is using stockholders money to build the company.
It compares the gains in EPS to gains in book value per share.
Dividend payout ratio is that percentage of profits paid out to stockholders. Keep in mind that every dollar paid out in dividends is one dollar less to grow the company with.
Formula: Sustainable Growth Rate = ROE * [1 - dividend payout ratio]
Company’s ROE is 20%.
Dividend payout ratio is 10%.
What is the Sustainable Growth Rate?
0.20 * [1.0 — 0.10] = 0.20 * 0.90 = 0.18 = 18%
Good guideline to determine forecast EPS: Keep forecast EPS estimate lower than Sustainable Growth Rate.
The ROE value used is the average for the last 5 years where ROE is calculated as the EPS for the given year divided by the prior year’s Book Value per Share.
The rational for calculating ROE in this manner is that this year’s EPS is the result of last year’s Book Value.
Addendum to Sustainable Growth Rate comments by Ellis Traub
As happens so often, we can get carried away with the formulae and the numbers and lose sight of the concepts.
A company begins the year with $100 million in equity.
And, during the course of that year, it earns $15 million for a return on that equity of 15 percent.
If it retains all of what it earned, the equity will have grown 15 percent.
And, since the company was able to make 15 percent on its equity, those retained earnings should also be able to earn 15 percent in the next year.
Similar to compounding, this shows that the sustainable growth, just the growth produced by those retained earnings, be 15 percent.
Companies aren't restricted from growth above that rate. They use a variety of resources to increase or perpetuate a higher rate.
They include leverage (using other people's money) to acquire the assets that generate more revenue, or they sell more shares.
While those shares might dilute the EPS, they were sold not given away, so they do add to the equity of the company.
Acquiring productive assets, acquiring operating companies, etc. are only a few of the things that managements, or directors, commonly do to exceed the sustainable growth rate.
So, of what interest is it to us?
It's just a simple metric that tells us that, without doing these other things, the company can still grow at that rate.
The only thing that might keep the ROE, sustainable growth, and earnings growth from being the same is the prospect of not using all of those earnings to produce more but, instead, to pay out some of those earnings in dividends.
This, of course, would reduce the amount of money that is available to earn more; and it will, therefore, cut down the sustainable or implied growth rate.
Otherwise, if dividends are not paid, the ROE and earnings growth rate will be the same, as will Implied growth.
If earnings growth falls, so will the ROE.
This formula (Implied growth = ROE * RR) [RR=Retention ratio, the percent of earnings NOT distributed to shareholders] will not work if you use ending or average equity.
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