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Value-Based Finance: A Six-Part Series
Part Six: Sustainable Growth
Affordable Dividends

April 2007We conclude our series of value-based finance articles with a discussion and analysis of how fast a company can grow sales (revenue) without issuing new common stock, along with how much cash can be paid out in dividends in light of growth plans and strategies.

These are the final elements of a "value-based" financial system and are focused on cash flow. They've taken on increased relevance due to some recent events:

  • The recent state of the equity markets. More stable share prices have been the norm for many public companies (versus the "go-go" years in the 1990's). Some of the high growth stocks of this period have matured and are now paying dividends to common shareholders, as opposed to striving for capital gains alone.
  • In the privately owned sector, dividends are a way to return capital to investors.
  • New federal legislation has reduced the tax burden of common stock dividends.

Thus, we have two related issues ... "sustainable growth" and "affordable dividends". The approach we'll take to discuss and analyze will be as follows: first, describe the concept; second, present the formulae used for analysis; third, provide an example.

To begin, we can state that "growth" is the most critical "driver" of shareholder value creation. Granted, this growth has to be "profitable" (defined as generating a return on new capital invested that is above the cost of capital) for any meaningful value creation to occur. (An interesting sidelight is that if the company does not have a return on investment above the cost of capital -- also known as a positive "economic" profit -- this whole subject is moot, since no shareholder value will be created beyond the investment made to fuel the future growth.) We'll take a positive attitude and assume we have a company with the potential for real value creation -- designated as Co. 'A' in prior articles.

Common stock was often the "currency" of the 1990's for financing growth via acquisition, fueled by accounting rules that encouraged a technique known as "pooling of interests" -- artificially inflating returns from such ventures. While common stock is still used to finance many deals, its use has been curtailed -- at least in relative terms. "Pooling" is gone and debt financing is coming back into play in many deals.

A debate that has raged for a long time in financial circles is the trade-off between immediate proceeds to shareholders via cash dividends and potentially greater long-term returns through new investment for future growth and profitability. Shareholders evaluate this trade-off in their investment decisions -- factoring in their risk tolerance, tax status and return goals. With the former onerous income tax issue being mitigated, the choice of substituting a dividend for future capital gains can be a "hot button" and, thus, upfront on the radar screens of corporate directors, CEO's and CFO's.

This article will focus on the "analytic" aspect of the topic, with a goal of equipping managements and boards with tools for evaluating future growth and deciding how to best enrich shareholders, along with giving investors and lenders a perspective and set of techniques to look deeper inside the cash flows of companies they provide capital to.

Sustainable Growth

Conceptually, sustainable growth is a "break-even" analysis from a net cash flow perspective -- that is, how fast can a company increase revenue (sales) without the need for new equity financing. A couple of conditions are necessary to calculate Sustainable Growth:

  • The company (business) has to be profitable, preferably from an "economic" perspective.
  • Investment needs have to be described in a linear fashion. I suppose we could employ higher-level mathematics to deal with a curvilinear or step-function type of investment intensity, but that's beyond the scope of this writer and most who would use the concept to help manage a company. The task, here, is to determine a pattern of investment that links to and expresses the financial impact of the firm's collective business strategies -- especially if a future pattern may differ from one in the past or present.

Exhibit 1 illustrates the concept.

A profitable business will normally generate "surplus" cash flow (that is, it throws off more cash than it consumes) at low rates of growth. At some point (the "break-even" growth rate) net cash outflow equals net cash inflow. At higher levels of growth, net cash flow becomes negative. At this conceptual stage, the numbers are purely hypothetical.

A key assumption is that the firm will either maintain some level of debt financing ("leverage") or establish a debt-to-total capital (D/TC) structure that lenders will finance at reasonable cost. Such a D/TC structure should be consistent with the nature and strategy of the business. That is, if the business strategy is risky with a wide range of expected financial outcomes, then the "leverage" will be more conservative than it would be with a less risky strategy and more predictable financial results. Other considerations include the type and level of assets employed in the business.

An interesting aspect of Sustainable Growth is how operating and financial management exert influence. Operating management generates cash flow via profit and consumes cash by investing. Financial management reduces retained earnings with a dividend payout and raises new capital through borrowing. The formulae for calculating sustainable growth are outlined in Exhibit 2.

Sustainable Growth incorporates the "net" income of the business. Thus, interest expense is included since it is a cash expense -- a departure from the typical "economic" profit formula that excludes interest and focuses on operating income. However, similar to a net operating profit calculation, deferred taxes should be analyzed to determine any difference between the tax provision and the actual tax paid. Thus, "retained earnings" will be a combination of the traditional definition and any change in deferred tax.

The first term in the "cash generated" formula is called the Financing Factor. It is a fraction whose result is expressed as a ratio and is comprised of:

  • The numerator -- net profit less dividend payout as a percent of net profit -- which yields a retained earnings ratio, and
  • The denominator -- new financing as retained earnings are "leveraged" according to the debt-to-capital ratio. In the formula, we reverse the terms and use an "equity-to-total capital" ratio.

The second term is straightforward -- the Net Profit Margin -- as is the third term, prior year Revenue (Sales) plus anticipated growth. The combination of these three terms will determine "cash generated".

The key term in the "cash consumed" formula is Invested Capital Intensity (ICI). Basically, ICI expresses the "net" capital needed to operate and grow a business as a ratio to revenue (sales). ICI encompasses working and fixed capital, along with intangible and other assets -- net of payables and accruals. As mentioned earlier, Sustainable Growth analysis for the firm should incorporate the capital needs of the business strategies.

Sustainable Growth can be calculated as an absolute (dollar) amount or a percentage (compound growth rate -- CGR).
The absolute (dollar) level of sustainable growth is usually calculated for an annual period; e.g., the next fiscal year. The formula is as follows:

The sustainable percentage growth is usually determined for a multi-year period; e.g., the next three years. The formula is as follows:

Our example is an industrial company with the following financial characteristics:

  • Revenue -- $500 million
  • Net income -- $28 million, or a 5.6% margin
  • Invested Capital -- $230 million, or an ICI of $.46
  • Dividend Payout -- 20% of Net Income (thus, Retained Earnings of 80%)
  • Debt-to-Total Capital Ratio (D/TC) –25% (thus, Equity-to-Capital of 75%)
  • Financing Factor is the Retained Earnings Ratio combined with the E/TC ratio. Dividing .80 by .75 yields a factor of 1.07.

To keep the calculations simple, we'll assume that the net income margin, ICI and financing factor will be at the stated levels for the foreseeable future.

The absolute level of sustainable growth for, say, the upcoming fiscal year is calculated as follows:

The percentage rate of growth that is sustainable for, say, the next (#) years is calculated as follows:

What this analysis does is to establish an "upper limit" for growth. For many companies, this may not be today's most pressing concern and, if double-digit annual growth rates are a "pipe dream", the analysis may get relegated to the "back burner". If margins fall, lenders pull back, or postponed capital spending becomes a necessity, then sustainable growth will be an issue -- albeit for a different reason. Strategic reactions could range from outsourcing "non-core" activities to curtailing growth or exiting a business.

If profitable growth opportunities beyond the "sustainable" level emerge, management has a different challenge -- since, in theory, all such growth should be funded. In the current climate, the prospect of having to issue more shares (versus a few years ago) to raise a given level of financing, could erupt into a serious governance debate. One solution is to raise the "leverage" (debt) ratio. However, two questions arise. First, will banks or others lend at this level? And, second, is an increase in the debt ratio "prudent" from an internal financial risk perspective? Another option is to provide more cash for investment by reducing the dividend payout, but that brings us to the other aspect of this discussion -- the potential for more favorable tax treatment on dividends and the assurance of a near-term return versus the uncertainty of a longer-term reward.

Affordable Dividends

What we'll do now is "flip" the analysis and determine -- for those firms who think that dividends might now be the "cool thing" to do for shareholders (especially companies that have seen their market values deteriorate or have limited value-creating growth opportunities) -- how much can be paid out and still finance future plans.

The concept of affordable dividends is quantifying how much (cash) can be returned to shareholders -- over a defined time period. The framework for the analysis assumes that a growth plan is in place (with absolute and rate of growth established). The purpose can range from setting a new dividend payout to revising or validating a current payout.

The formulae are integrated into a two-step process:

  1. Determining the Financing Factor ("F"), and
  2. Calculating the Earnings Retention ("ER") Ratio, from which the Dividend Payout Ratio falls out. This will yield a percentage payout. A subsequent step will then compute the absolute amount of affordable dividends.

We start with our Sustainable Growth Rate formula and then rearrange the terms to perform the analysis.

Here's what rearranging the terms results in:

N. I. % times "F" equals "Plan CGR" times [ICI minus (N. I. % times "F")]

Solving this equation will determine the Financing Factor ("F").

The Earnings Retention ("ER") ratio, is

Let's use our example to quantify the situation.

First, the Sustainable CGR or, "Plan CGR":

Next, rearrange the terms:

.056 times "F" equals 15% times [.46 minus (.056 times "F")]

And then, solve the equation:

For those who paid attention in Algebra class, this should be a "breeze". For those who "gazed out the window at trees blowing in the breeze" ... you may have to suffer!

Next, is the Earnings Retention ("ER") Factor:

If the earnings retention factor is 80%, then the maximum dividend payout (Affordable Dividend) ratio is 20% -- the ratio expressed as a percent of "cash-based" Net Income.

The final step is to calculate the Affordable Dividend in absolute terms -- for us, dollars. For this, we have to set a time frame -- let's say, three years. The "Plan" that forecasts growth of 15% per year and maintains the net income margin at 5.6% results in the following:

The Affordable Dividends over the next three years would total about $22.5 million (20% of $112 million).

To conclude, we have analytic tools for Sustainable Growth and Affordable Dividends. These tools can be used to quantify how the financial dynamics of a firm impact its ability to grow and pay dividends. They can enhance judgment about company prospects and help management make more informed decisions about the course of future growth and shareholder value. Armed with this framework and process, managements and boards should be better able to evaluate what may be challenging issues in the years ahead. Investors and lenders should also find the approach and techniques useful, as they grapple with how to optimize their returns in these uncertain times.

Return to Value-Based Finance: A Six-Part Series

ROY E. JOHNSON can be contacted at or 203.438.1240. This article is extracted from material in the author's book, Shareholder Value -- A Business Experience, published in October 2001 by Butterworth-Heinemann, a unit of Elsevier:

2007 SmartPros Ltd. All rights reserved.

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