Question

Typically the calculation for sustainable growth in earnings per share = (1 - payout ratio)x (Return on equity).

a. Can you use the same equation to compute growth in operating income?

b. Under what assumptions will this sustainable growth rate also be equal to your expected growth rate?

c. Increasing the amount you reinvest back into the business (reduce the payout ratio or increase the reinvestment rate) will increase the growth rate for any company that is prfitable. Will it also increase value?

Answer 1

a. No, the formula for calculating the operating income is slightly different,

the expected growth in opertaing income is = (CAPEX - DEPRECIATION + CHANGES IN WORKING CAPITAL )/ AFTER TAX OPERATING INCOME * RETURN ON CAPITAL

RETURN ON CAPITAL = AFTER TAX OPERATING INCOME/ BOOK VALUE OF EQUITY +_ BOOK VALUE OF DEBT

B. the sustainable growth rate = expected growth rate only if the return on equity is constant over time.

if we expect the return on equity to increase to 12%, out of which, we will reinvest 70%,

we can expect the growth rate to be:

0.7* 0.12 + 0.12 - 0.10/ 0.12 = 25.06%,

the growth rate can be decomposed into 2 parts

1. growth from new investments 2. growth from the efficient use of existing assets . at some point the assets will be optimally utilized and we may no longer be able to extract growth. that is why we cananot count sustainable growth as the perpetual growth.

c. no, it depends on the return on equity greater than the cost of equity, if the return on capital is less than the cost of capital then increase in the reinvestment rate will increase will increase growth but reduce value. if it is equal increasing reinvestment will not increase value. it is growth with excess returns that is a source of value.