While analyzing a company’s fundamentals, we try to look at its past performance and growth rates to assess its financial strength. However, while this analysis can give you an idea about how the company has performed to date it does not assure us about the company’s performance in the future.
The equation is simple – the return on your investments depends upon the future growth of the company.
Therefore, assessing its growth potential is essential to making sound investment decisions. Today, we will be talking about how you can determine a realistic growth rate for the company that you are analyzing.
We will be looking at various ways in which you can calculate this effectively. But before we begin, we would like to highlight some common ways that investors use to calculate this.
Predictions Made by Analysts
Some investors find company analysis frustrating and tend to read through some analysts’ findings. There are many equity analysts that offer predictions about the expected growth rate of a company by sifting through volumes of data and information. However, it is important to remember that while these analysts are experts in their field, their predictions can be way off the mark. Hence, while this could be considered as a starting point, however, it is not enough to make investment decisions.
Historical EPS Performance
Another way used by investors to gauge the growth prospects of a company is by looking at its growth over the last decade. They use this data to extrapolate into the future. This can be counterproductive too because as the company grows, it becomes increasingly difficult to maintain its rate of growth. Hence, while the historical EPS performance can be a good way to assess the growth of the company to date while estimating its potential, it is important to consider the fact that as the company grows, its growth rate tends to shrink.
Return on Equity
Some investors use Return on Equity (RoE) as an indicator of the growth of the company. So, a company with a history of constantly increasing RoE is usually perceived as one with good growth potential.
However, this is looking at the company dynamics in a simplified manner. If the company reinvests its entire earnings (or at least a major part of it), then its RoE keeps increasing. However, in the real world, a company cannot continuously reinvest its earnings. It might decide to pay out dividends or replace/maintain equipment that might not contribute to the growth of the company. Which brings us to..
The Best Way to Assess a Company’s Growth Potential
1. Sustainable Growth Rate
To accurately assess the growth potential of a company, we will first look at the Sustainable Growth Rate which is the maximum rate at which a company can grow without taking on more debt. This is important because as an investor, you would want to invest in a company that can fund its growth with its earnings. The formula to calculate it is as follows:
Sustainable Growth Rate = Return on Equity x (1 – Dividend Payout Ratio)
In simpler terms, this formula takes the RoE ratio and makes adjustments for dividends paid out by the company. This gives you a clearer picture of the expected growth rate. Let’s understand this with the help of an example:
A Company has an RoE ratio of 25%. However, it pays out 40% of its earnings as dividends. Hence, its expected growth rate will be much lower than RoE. As per the above-mentioned formula,
Sustainable Growth Rate = 25% x (1-40%) = 15%.
Hence, it will be safe to consider a Sustainable Growth Rate of 15% for the company.
However, the Sustainable Growth Rate is the maximum rate at which the company can grow. As an investor, you would be more interested in the realistic rate as opposed to the maximum rate. And so, Sustainable Growth Rate is not ideal either.
2. Realistic Growth Rate
Let’s say that a Company takes a long-term debt to boost its operations and increase its earnings. While the shareholder equity figure will remain the same, the earnings would rise showing a higher RoE ratio. In such cases, the RoE can be flawed since the debt has not been taken into account.
Also, since RoE is the key component of the Sustainable Growth Rate, it is not accurate either. Additionally, as mentioned above, the RoE does not take into consideration any amount spent by the company and repairs and maintenance.
To get a more realistic assessment of the growth potential of the company, it is hence important to take the long-term debt into consideration. Therefore, instead of looking at the RoE ratio, you should look at the Return on Capital ratio. Further, take the total of depreciation and amortization expenses and deduct it from the reinvested earnings to get a more accurate estimate of the amount available to the company for pushing growth.
To put it in a formula:
Realistic Growth Rate = (Net Income – Depreciation – Amortization – Dividends) / (Shareholders’ Equity + Long-term Debt)
This is as close as you can get, to assessing the growth potential of a company. Is it perfect? No. There are several assumptions that are still a part of this estimate. However, it does offer a fair view of how fast the company can grow. Also, to keep things in check, you can compare this rate with the historical EPS growth rate of the company and ensure that you are not being too optimistic. You can also look at the earnings of the company over the last decade. Consistent growth in earnings can be considered as a good sign too.
As you can see, calculating a company’s growth potential is not easy. In fact, making any investment-related prediction is risky and should be done carefully. Remember, there is no perfect way of estimating the growth potential of a company (Sorry! No crystal ball either!). Use the options specified above and try to get a comprehensive view of the company before making a decision. Hope this was helpful!
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