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).
