Why Is Growth Analysis Important?
To find out how fast a firm is growing or is expected to grow, analysts must examine a set of ratios that indicate what the firm’s sustainable growth potential is.
A company’s growth potential analysis is of paramount importance to both lenders and investors. Investors want to be assured that their investments will generate at least the required rates of return, if not exceed them, for they recognize that the future growth rate of a company is positively correlated to growth rates of its earnings and cash flows.
Lenders are also very interested in a company’s analysis of growth potential because they need to know whether the company will be able to meet its financial obligations or not.
Notably, the more a company is growing, the more money is left over and available to cover any outstanding liabilities due to the lender.
For example, some lenders watch for ratios that use book values of a company’s assets. The assumption is that selling at book values is the worst case scenario.
Consequently, if there is enough money left over to cover what is owed to the lender after selling off the company’s assets at book values, the lender is generally considered to be in good shape.
What Determines Growth Potential of a Company?
As is the case with the overall economy, growth of a company depends on the following:
- resources either retained or reinvested; and,
- the rate of return earned on reinvested capital.
The reasoning is quite simple—the more capital is reinvested, the greater its growth potential. In other words, considering how much capital is reinvested back into a company, it will grow that much faster if it can earn higher rates of return on reinvested capital.
This is how investment analysis theory has arrived at the conclusion that growth rates of earnings and cash flows depend on two variables:
- a company’s retention rate; and,
- the rate of return earned on the company’s equity capital (ROE).
As a result, a company’s growth rate is calculated as follows:
g = Percentage of Retained Earnings x Return on Equity; or, g = RR x ROE; whereby:
- g = potential (sustainable) growth rate;
- RR = earnings retention rate; and,
- ROE = return on equity.
Note that the board of directors decides the percentage of earnings to be retained from a company’s profits. In theory, the company should reinvest retained earnings (those not distributed to shareholders via dividends), provided its expected rate of return is greater than its cost of capital.
Analysts can derive a company’s earnings retention rate as follows:
Retention Rate = 1 – (Dividends Declared / Operating Income after Taxes)
Revisiting the DuPont Model
According to the DuPont Model, a company’s return on equity is a function of three factors: a company’s net profit margin, total asset turnover and its financial leverage.
So, if the company wants to boost its return on equity, “all” it has to do is to figure out how to become more profitable, more efficient in the use of its resources and capital, and how it can get away with higher financial risk.
In conclusion, the company’s return on equity determines what its sustainable growth rate is. It is important to consider the long-term outlook of the three growth components included in the DuPont Model.
Investors would be wise to make estimates with respect to each of the components and project any observable changes into the ROE calculation.
Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown,