Importance of Growth Potential
The analysis of sustainable growth potential examines ratios that indicate how fast a firm should grow. Analysis of a firm's growth potential is important for both lenders and owners. owners know that the value of the firm depends on its future growth in earnings, cash flow, and dividends. In the following chapter, we discuss various valuation models that determine the value of the firm based on your required rate of return for the stock and the expected growth rate of the firm's alternative cash flows.
creditors also are interested in a firm's growth potential because the firm's future success is the major determinant of its ability to pay obligations, and the firm's future success is influenced by its growth. Some financial ratios used in credit analysis measure the book value of a firm's assets relative to its financial obligations, assuming the firm can sell these assets to pay off the loan in case of default. Selling assets in a forced liquidation will typically yield only about 10 to 15 cents on the dollar. currently, it is widely recognized that the more relevant analysis is the ability of the firm to pay off its obligations as an ongoing enterprise, and its growth potential indicates its future status as an ongoing enterprise. This analysis is also relevant if you are interested in changes of bond ratings.
Determinants The growth of business, like the growth of any economic entity, including the aggregate econ-of Growth omy, depends on
1. the amount of resources retained and reinvested in the entity, and
2. the rate of return earned on the resources retained and reinvested.
The greater the proportion of earnings that a firm reinvests, the greater its potential for growth. Alternatively, for a given level of reinvestment, a firm will grow faster if it earns a higher rate of return on the resources reinvested. Therefore, the growth of equity earnings is a function of two variables: (1) the percentage of net earnings retained and reinvested into the business (the firm's retention rate) and (2) the rate of return earned on the firm's equity capital (the firm's ROE) because when earnings are retained they become part of the firm's equity (i.e., its retained earnings). This can be summarized as follows:
g = Percentage of Earnings Retained x Return on Equity = RR x ROE
g = potential (i.e., sustainable) growth rate RR = the retention rate of earnings ROE = the firm's return on equity
The retention rate is a decision by the board of directors based on the investment opportunities available to the firm. Theory suggests that the firm should retain earnings and reinvest them as long as the expected rate of return on the investment exceeds the firm's cost of capital.
As discussed earlier in the chapter, using the DuPont system, the firm's ROE is a function of three components:
> Net profit margin
> Total asset turnover
> Financial leverage (total assets/equity)
Therefore, a firm can increase its ROE by increasing its profit margin, by becoming more efficient (increasing its total asset turnover), or by increasing its financial leverage and financial risk.
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