A new feature in the upcoming release of The Stock Investment Guide version 3.1.3 is a sustainable growth calculation. This calculation is made using the formula:
Growth = ROE * (1-Payout Ratio)
Where ROE is Return on Equity
The Sustainable Growth calculation indicates how much growth ability a company can sustain without borrowing additional funds. The only way to increase the sustainable growth is increase ROE or to decrease the dividend payout.
Let’s look at a couple of sample calculations as an example.
Apple Computer
Apple’s 2010 ROE was 29%, and they do not pay a dividend.
Growth = ROE * (1-Payout Ratio)
Growth = 29 * (1-0)
Growth = 29%
This indicates that Apple can sustain a growth rate of 29% without additional borrowing. Of course, this does not mean that we should use 29% for our stock analysis, but the sustainable growth provides insight in how much is possible.
Proctor & Gamble
Proctor & Gamble had a 2010 ROE of 16.8%, and a dividend payout ratio of 51%.
Growth = ROE * (1-Payout Ratio)
Growth = 16.8 * (1 - .51) = 16.8 * .49
Growth = 8.2%
So Proctor & Gamble’s sustainable growth calculation indicates they can grow at 8.2% without borrowing. Zacks is estimating 2011 growth at 8.6% which is similar. For P&G to achieve 8.6%, they would need to improve ROE, decrease the dividend, or use cash on hand.
If you are performing a stock analysis of P&G with an EPS growth estimate of 10%, then you should reconsider your assumptions. The sustainable growth calculation doesn’t imply that P&G can’t grow at 10%, but as a stock analyst you need to understand how growth is sustained by P&G.
The Sustainable Growth calculation is available in the Stock Investment Guide 3.1.3 (and forthcoming versions). Version 3.1.3 will be released Thanksgiving week (2010) and is a free update for all SIG 3 users.