Internal and sustainable growth rate estimation

David J. Moore, Ph.D. October 16, 2012

Abstract Given a rms ability to translate assets into sales and ability to convert sales into earnings I derive two growth rate estimates. The rst estimate, internal growth rate, measures how much sales can grow without raising additional funds. The second estimate, sustainable growth rate, measures how much sales can grow while issuing debt and maintaining the current debt-to-equity ratio (i.e., risk). These measures are useful in discounted cash ow estimations and as a check of the true amount of growth potential.

Additional funds needed

A 0 S0 L 0 S0

The additional funds needed for an increase in sales S is estimated by: AF N1 = S S P M RR S1 (1)

with variables dened as follows: Variable S0 A 0 L 0 PM RR S1 S Denition Sales in the current period Assets required to support sales S0 Liabilities that increase spontaneously with sales S0 L = accounts payable + accruals 0 Prot margin income P M = netsales = N I0 S0 Retention ratio dividends RR = 1 net income = 1 Div00 NI Sales forecasted in next period Change in sales S = S1 S0

With an increase in sales S, the required asset increase (A0/S0 ) S is paid by suppliers and employees (L0/S0 ) S and retained prots P M RR S1 . If assets are fully utilized then the assets required to support sales A equals 0 total assets A0 . To generalize, given capacity utilization , A = A0 . If we 0 1

presume a growth rate g we can substitute S1 = (1 + g) S0 and S = S1 S0 = (1 + g) S0 S0 = gS0 into Eq. (1): AF N1 = A0 S0 gS0 L 0 S0 gS0 P M RR S0 (1 + g)

= A0 g L g P M RR S0 P M RR S0 g 0 Grouping the g terms together: AF N1 = A0 g L g P M RR S0 g P M RR S0 0 (2)

Internal growth rate

The internal growth rate IGR is the maximum growth rate attainable without raising any additional funds. Assets must increase to support an increase in sales. The question is, who is going to pay for those assets? With IGR we determine how much sales can grow using internal funds only. Those internal funds are the retained prots from the new level of sales. To nd IGR set AF N1 = 0 in Eq. (2) and solve for g: 0 = A0 g L g P M RR S0 g P M RR S0 0 = g (A0 L P M RR S0 ) P M RR S0 0 IGR g = P M RR S0 A0 L P M RR S0 0 (3)

Eq. (3) can be expressed in terms of ROA by noting the relationship between P M and ROA: PM = N I0 S0 N I0 A0 = A0 S0 A0 = ROA S0

(4)

Substituting Eq. (4) into Eq. (3): ROA IGR =

A0 S0

RR S0
A0 S0

A0 L ROA 0

RR S0

ROA A0 RR S0 A0 L ROA A0 RR S0 0 ROA RR L0/A0 ROA RR (5)

IGR =

Sustainable growth rate

Bankruptcy risk increases with the amount of debt. However, the retained prots from additional sales can oset the bankruptcy risk. In particular, if we allow debt issuance to fund growth but x the debt to equity ratio we can solve Eq. (2) for g to obtain the sustainable growth rate SGR. Another way to look at SGR is the maximum we can grow by using other peoples money without increasing overall risk of the rm. Let = AF N1 represent the additional debt issued to fund growth such that D1 = D0 + . We are constrained such that the debt to equity ratio is xed: D0 D1 = E1 E0 Solving for : D0 + D0 = E1 E0 D0 = E1 D0 E0

(6)

The new level of equity E1 is the sum of the old level of equity E0 plus additions to retained earnings ARE: E1 = E0 + ARE = E0 + P M RR S1 = E0 + P M RR S0 (1 + g) = E0 + P M RR S0 + P M RR S0 g Substituting Eq. (7) into Eq. (6): = E1 D0 D0 S0 (7)

D0 D0 E0 D0 D0 = D0 + P M RR S0 + P M RR S0 g D0 E0 E0 N I0 D0 N I0 D0 = RR S0 + RR S0 g S0 E0 S0 E0 = ROE RR D0 + ROE RR D0 g = (E0 + P M RR S0 + P M RR S0 g) Substituting AF N1 = and P M = ROE E0/S0 into Eq. (2): AF N1 = A0 g L g P M RR S0 g P M RR S0 0 = A0 g L g (ROE E0/S0 ) RR S0 g 0 (ROE E0/S0 ) RR S0 = A0 g L g ROE RR E0 g ROE RR E0 0 3

(8)

(9)

Almost there! Now substitute Eq. (8) into Eq. (9): ROE RR D0 + ROE RR D0 g = A0 g L g ROE RR E0 g 0 ROE RR E0 ROE RR (D0 + E0 ) = g (A0 L ROE RR (D0 + E0 )) 0 g (A0 L ROE RR A0 ) = ROE RR A0 0 ROE RR A0 g= A0 L ROE RR A0 0 SGR g = ROE RR ROE RR

L/A0 0

Conclusion

To increase sales a rm must increase assets. The increase in assets must be paid for by internal or external funds. I derived the maximum growth rate based on internal funding, internal growth rate or IGR as: IGR =
L/A0 0

ROA RR ROA RR

I derived the maximum growth rate based on external debt nancing while maintaining the current debt to equity ratio, the sustainable growth rate or SGR as: ROE RR SGR = L0/A0 ROE RR These growth rate estimates can be used in discounted cash ow (DCF) analyses and as a check for maximum possible growth rates given the rms current asset management and operational eciency. Use of growth rates in DCF models higher than IGR and SGR must be supported by evidence of future increases in asset management or operational eciency.