Firms With High Sustainable Growth
Apple’s decision to initiate a dividend highlights the trade-off between distributing profits to shareholders and preserving excess cash to fund future growth. Dividends are normally paid by more mature companies that are generating free cash flow and no longer need as much money to fund expansion and growth. The sustainable growth rate is a common calculation that examines the profitability of a firm and how the dividend payment may impact its growth potential. If a firm does not make significant changes to its assets or financial structure, the sustainable growth can be calculated by multiplying the return on equity by the percentage of earnings retained by the firm.
The return on equityis equal to earnings divided by shareholder equity (book value) of the firm. The higher the ROE, the more successful the firm has been in acquiring and managing assets that generate income and in financing assets through debt, common stock and retained earnings. ROE can be increased with higher profit margins, more efficient use of assets, or higher levels of debt relative to equity.
The percentage of earnings a firm retains, while generating the same ROE, determines the future earnings growth and provides an indication of its sustainable growth rate. Called the retention ratio, it is equal to one minus the ratio of dividends to earnings per share (the payout ratio). When all earnings are retained, the ratio is 1.0, or 100%. If a quarter of the earnings are paid out, the retention ratio is 0.75, or 75%. The higher the ROE and the greater the retention ratio, the higher the sustainable growth rate.
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