Sep 18, 2010

Sustainable Growth: Is There Room to Grow?

After a period of cutting costs and improving controls in response to the dot-com bust, 9/11, and various corporate scandals, CEOs are increasingly focused on generating growth. But do companies have the requisite financial growth. ? To answer this question, the sustainable growth rates across industries in the U.S. were analyzed in order to determine how well the operating performance and financial policies of firms are aligned with their anticipated growth. The aggregate results are significant: the sustainable growth rates for the S&P 500 (based on 2004 calendar year data) exceed the forward 3-year compounded annual growth in revenue.
This suggests that, on average, S&P 500 companies can continue to expand without new equity issuance.

What is Sustainable Growth?
In a nutshell, sustainable growth rate, or SGR, is the maximum pace at which a company can grow revenue without depleting its financial resources. SGR is calculated by multiplying ROE, or return on equity, (using beginning-of- period equity) by the companyís earnings retention rate (1 - dividend payout ratio). This can be expanded as follows:
     SGR      = ROE * Earnings Retention Rate
                   = (Profit Margin * Asset Efficiency * Capital    Structure) * Retention Rate
                   = [(Net Income/Sales) * (Sales/Assets) * (Assets/   Beginning of Period Equity)] * (1 - Dividend  Payout Ratio)
This metric assumes that over the evaluation period: (1) the company will grow sales as rapidly as market conditions permit; (2) management is unwilling to sell new equity; and (3) the company maintains it current capital structure and dividend policy.  As growth requires commensurate increases in assets for support ó without equity issuance, any asset increases must be funded with added liabilities or from retained earnings. Thus if financial policies are unchanged, the rate of shareholder equity growth will limit sales growth.
The sustainable growth rate is particularly valuable because it combines companiesí operating (profit margin and asset efficiency) and financial (capital structure and retention rate) elements into one comprehensive measure. Using SGR, managers and investor can begin to gauge whether the firmís future growth plans are realistic based on their current performance and policy.  In this way, SGR can provide managers and investors with insight into the levers of corporate growth.  Industry structure, trends, and competitive positioning can then be analyzed to find and exploit specific opportunities.
A Closer Look at the Results
Analysis of the S&P 500 shows that the sustainable growth rate in most industries exceeds the projected 3-year forward compounded annual growth (see exhibit 1). This reality has powerful implications for the managements and shareholders of many of the largest U.S. firms. When SGR exceeds the sales growth rate it means the company is not fully utilizing its financial resources to generate shareholder value. In fact, the analysis suggests that there is excess liquidity in the S&P 500. Similarly for current data, the sustainable growth rate slightly exceeds the actual growth rate in most industries with the exception of information technology, energy, materials, and telecom services (exhibit 2).
By adopting a two-pronged approach companies can guard against suboptimal growth, while at the same time maintaining a strong financial position. First,determine if growth is indeed available in the industry. If so, invest in the capital equipment and capacity to capture growth in existing markets.  If not, consider diversification through new investments in product development or synergistic M&A to buy growth.  If the above opportunities are unattractive, companies should consider returning excess cash to shareholders through dividends or share repurchases.  This will bring the sustainable and actual rates more in-line.



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