MSG Team's other articles

10666 Poor Risk Management at the Silicon Valley Bank

The entire world is still trying to grapple with the failure of the Silicon Valley Bank. The impact has been felt across the United States economy and even across the entire world. It is obvious that since the impact has been significant, a lot of time will be spent trying to analyze if this financial […]

9189 How Epic Games Changed the Gaming Industry?

The gaming industry is notorious for being full of fads. Games tend to become popular very soon. However, their popularity dwindles at a greater pace as the next attraction hits the market. This is the reason that gaming customers have been known to be fickle and inconsistent. As a result, building a multi-billion dollar in […]

11895 What is Sports Franchising?

We all know that professional sports teams are run like a business across the globe. This means that these sports teams have professional marketing agents, an executive team, and a finance team and operate like a full-fledged organization. These professional teams are often referred to as sports franchises. Football clubs in the English Premier League, […]

10097 The Ketan Parekh Scam

The Ketan Parekh scam was the second most important scam that rocked the Bombay Stock Exchange after the Harshad Mehta scam. To make matters worse, Ketan Parekh was himself a protege of Harshad Mehta and had learned stock trading from the pied piper of Bombay Stock Exchange himself. As a result, he was able to […]

8764 Why are Pension Funds Important?

Individual investors are well aware of the existence of pension funds. Retail investors who earn their income in the form of a salary are likely to have invested in these funds. Other retail investors may also have invested in these funds. Almost everyone has heard about pension funds in the news. However, very few people […]

Search with tags

  • No tags available.

We now have a basic understanding of the concept of sustainable growth rate and how it related to the valuation of any given firm. In this article, we will dig deeper in the same formula in an attempt to connect it with the famous Du-Pont model which is used worldwide to predict the Return On Equity or the ROE number.

Let’s look at this concept in greater detail in this article:

The Sustainable Growth Rate Formula:

The sustainable growth rate formula is pretty straightforward. It is derived based on two factors. One of those factors is the retention rate of earnings or “b” and the other is the Return on Equity or ROE. Hence, the ROE number is an important determinant of the formula.

However, in real life, it is very difficult to predict what the ROE number for the future periods will be. It is for this reason that Du-Pont analysis had been created in the first place. Since ROE is a determinant of the sustainable growth rate, Du-Pont analysis is also intertwined with the concept of sustainable growth rate. This article will explain the correlation

Breaking Down the ROE – The PRAT model:

The formula for sustainable growth rate is

SGR = b * ROE

Where b represents the retained earnings i.e. (net income – dividends)/ net income

And ROE represents the return on equity which can be broken down into its 3 component ratios with the Du Point analysis

table.formulaTable{border:1px solid black;/*border:none;*/text-align:center;}table.formulaTable td{text-align:center;padding:5px;spacing:5px;}table.formulaTable td.numerator{border-bottom: solid 1px black;}
SGR = (net income – dividends) X(net income)X(Sales)X(Total assets)
Net incomeSalesTotal AssetsEquity

We can see that the Du-Pont analysis has been further developed in this model. Just like the Du-Pont ratio is internally made up of 3 ratios, similarly the sustainable growth rate ratio is also internally made up of 4 ratios viz, P, R, A and T

Where:

P represents profit margin

R represents retention rate

A represents Asset Turnover

And surprisingly T represents Financial Leverage

Note that leverage is not represented by L. Rather it is represented by T

Example:

If a company has a profit margin of 14%, asset turnover of 2, leverage ratio of 1/2 and pays out 60% of its earnings as dividends, then what is the rate at which this company can grow indefinitely?

Answer:

Since 60% of the earnings are paid out, the balance 40% are retained.

Therefore SGR = 14% * 0.4 *2 *0.5

= 5.6%

Hence as per the above inputs the company can continue to grow at a rate of 5.6% indefinitely. However, obviously the underlying assumption states that the capital structure policy and the dividend policy remain unchanged!

The PRAT model is important from an exam point of view. This is because it helps us calculate the Sustainable Growth Rate even though the components of sustainable growth rate may not be explicitly stated in the question paper.

Analysis: The Financing Factors:

From an analysis point of view, we can see that two out of the four factors in the PRAT model are directly linked to the financing policy of the company. These two factors are retention rate and asset turnover. Thus, while creating the financing policy companies must take into account the fact that they could be changing the valuation of their firm for better or for worse.

However, since these factors are within the direct control of the company, the prediction pertaining to these two components shows less error and tends to be more accurate.

The Performance Factors:

The other two factors viz. the profit margin and the asset turnover are performance driven. This means that they are not under the direct and unilateral control of the organization. There are factors beyond the reach of the company which can affect these components of the ROE and hence the sustainable growth rate number. The predictions pertaining to these components have a higher possibility of error and hence less accuracy.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Calculating Free Cash Flows: The Case of Preferred Shares

MSG Team

Calculating Free Cash Flow to Equity

MSG Team