Sustainable Growth Rate = Return on Equity X Retention Ratio

Tips, Tricks, & Techniques

SustainableGrowth Rate.

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]


Example:

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.



http://naicspace.org/pdf/sustainablegrowthrate.pdf


STOCK FUNDAMENTALS By Ellis Traub USING ROE TO ANALYZE STOCKS: WHAT YOU NEED TO KNOW ABOUT
http://www.aaii.com/journal/article/using-roe-to-analyze-stocks-what-you-need-to-know-about

Visual Analysis of Sales, PTP and EPS lines in Take Stock (Ellis Traub).

It might make it easier if you consider the Visual Analysis one piece at a time.

Does the Sales line look straight? That means Sales growth is pretty consistent; usually what we'd prefer to see.

Is the Sales line getting steeper recently? That indicates more rapid Sales growth, but is unusual. Generally Sales growth slows as a company gets older and bigger. If there is a sudden large upward "jag" in Sales that often indicates a large acquisition. A large acquisition is a situation that tends to make the rest of the Visual Analysis harder to interpret and the future harder to project.

Is the Sales line getting less steep recently? That indicates slowing Sales growth. Slowing Sales growth is "normal" as a company gets larger. However, as an investor, too much slowing that persists over time is not a good sign. BBBY is a classic example of this.

The gap between the PTP and Sales lines shows exactly the same thing as SSG section 2A (pre-tax profit margins). If the gap changes enough that you notice it on the Visual Analysis, then PTP margins probably changed significantly.

With Sales above PTP on the graph, a smaller gap is the same thing as higher PTP margins, which is a good thing. More of every dollar of Sales is being kept as profit (less of every dollar of Sales is being spent on expenses). A larger gap is the same as lower PTP margins (not so good).

Variation in PTP margins is normal so look for a trend. Seeing changes in PTP margins before they show up on the Visual Analysis or SSG section 2A is perhaps the primary reason for looking at PERT-A. Remember that PERT-A tells you the same story as the Visual Analysis, just from a different point of view. If you think they're telling different stories, you're reading at least one of them wrong (or there is a data error).

The gap between the EPS and PTP lines shows the combined effect of changes in tax rate and shares. Anything that changes the size of this gap is unsustainable. If the gap changes enough that you notice it on the Visual Analysis, the underlying change (taxes and/or shares and/or other things) is probably significant. So, if the EPS line is getting steeper but the PTP line isn't following suit, don't expect that situation to continue. Without further investigation, It's generally not possible to know just what things caused a change in the size of this gap (and just how good or bad those things might be).

Remember that when the Sales line changes direction (i.e., isn't straight), the PTP and EPS lines generally also change direction in about the same way. If they don't, that's a warning that you should investigate the cause. If the gap between Sales and PTP lines changes noticably, investigate why PTP margins changed. If the gap between PTP and EPS lines changes noticably, investigate why taxes and/or shares (and/or something else below PTP on the income statement) changed

-Jim Thomas


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I have an article in my BI binder from BI magazine, dated May 2006.  The title is, "Introduction to the income statement" and it is written by Ann Cuneaz.  In it, she talks about "reading the graph" from SSG section I, visual analysis.  Most people align the graphs in the same order as on an income statement: Sales on top, followed by pre-tax profit (PTP)and earnings per share (EPS). The gap between Sales and PTP represents expenses; the gap between PTP and EPS represents both taxes & number of shares.  If we only concern ourselves with graphs that have fairly straight lines for each of these three items, then we have seven different scenarios to consider: All three lines are parallel (preferably rising to the right or curving upwards to the right). This means expenses are under control and taxes & shares outstanding are holding steady.  This is an excellent situation. Sales and PTP are rising and parallel but EPS is diverging. This means expenses are under control but tax rate and/or # shares are increasing. Taxes cannot be controlled (much) so this is ok. However, an increase in shares indicates dilution and that's not good. PTP and EPS are parallel but flat; Sales are increasing.  This means profit margins are declining. This is not good. PTP and EPS are parallel and rising but Sales are flat. This means there has been an increase in efficiency (expenses are under control).  This is ok. Sales and PTP are parallel but flat; EPS is increasing. This means expenses are under control, and either or both taxes are being reduced (good) and/or # shares is being reduced. It was discussed here on the forum recently that although most people consider a share buyback to be a good thing, historically these stocks have not appreciated very well. Sales are flat, PTP is increasing, EPS is flat. This means expenses are decreasing (good) but taxes and/or shares outstanding are increasing. Again, taxes cannot be controlled and an increase in shares indicates dilution and that's not good. Sales are increasing, PTP is flat, EPS is increasing. This means expenses are increasing (not good), but taxes are declining (good) and/or # shares is decreasing (good). Bob Mann

http://community.compuserve.com/n/pfx/forum.aspx?msg=32627.1&nav=messages&webtag=ws-naic

You don't have to be a genius to make money in the market

NAVIGATE INTERVIEW

With four sons about to enter college, Ellis Traub lost everything.  Today, he's a widely respected author, spokesman for the NAIC, and CEO of Investware.  Learn how you can avoid the same mistakes he did - and save your pocketbook a lot of trouble.
 

• Part 1:A Walk: Ellis' Story
• Part 2:You Can Do It
• Part 3: Buy from a Sucker
• Part 4: Reader Questions