Managing Growth Dr C Bulent Aybar Professor of
Managing Growth Dr. C. Bulent Aybar Professor of International Finance
Financing Growth • Firms can finance their anticipated growth in two ways: – (1) internally, through the retention of profits (additions to retained earnings) or – (2) externally, through the issuance of shares and through borrowing. • Because external equity financing is more costly than internal equity financing, firms often try to finance their expected growth with internally generated equity (retained earnings). • For this reason, man agersneed to have an indicator of the maximum growth their firm can achieve without raising external equity. © Dr. C. Bulent Aybar
• The firm's self sustainable growth rate (SGR) is exactly this indicator. • It is the maximum rate of growth in sales a firm can achieve without is suingnew shares or changing either: – its operating policy i. e. its operating profit margin and capital turnover remain the same; or – its financing policy i. e. its debt to equity ra tioand dividend payout ratio remain the same. © Dr. C. Bulent Aybar
How is the self “Sustainable Growth Rate” is determined? • Let's start with a simple example and estimate the rate for TJX Distributors at the end of 2010. The firm's financial data is given in the following slides. • We know that the firm's $70 million of equity at the begin ning of 2010 (the same as end of 2009) generated $10. 2 million in earnings after tax. • The firm retained $7 million and distributed the balance of $3. 2 million to owners in the form of dividends. • As a result, owners' equity increased by 10 percent, from $70 million to $77 million. • If the firm wants to maintain its current debt to equity ratio, then its debt must also increase by 10 percent. © Dr. C. Bulent Aybar
Balance Sheet: Assets TJX Distributors Assets Current Assets Cash A/R Inventories Prepaid Expenses Total Current Assets Non Current Assets Financial Assets and intangibles Gross Property Plant and Equipment Accumulated Depreciation Net Fixed Assets Total Non Current Assets Total Assets Balance Sheet December 31 st (in millions) 2008 2009 2010 6 44 52 2 104 12 48 57 2 119 8 56 72 1 137 0 90 34 56 56 0 90 39 51 51 0 93 40 53 53 160 170 190
Balance Sheet: Liabilities TJX Distributors Liabilities and Shareholders' Equity Current Liabilities Short Term Debt Notes Payable Current Portion of LTD A/P Accrued Expenses Total Current Liabilities Non Current Liabilities Long Term Debt Total Non Current Liabilities Shareholders' Equity Total Liabilitties and Shareholders' Equity Balance Sheet December 31 st (in millions) 2008 2009 2010 15 7 8 37 2 54 22 14 8 40 4 66 23 15 8 48 4 75 42 42 64 160 34 34 70 170 38 38 77 190
Income Statement TJX Distributors Net Sales COGS Gross Profit SG&A Depreciation Special Items EBIT Net Interest Expense Earnings Before Tax Income Tax Expense Earnings After Tax Dividends Addition on R/E Income Statement December 31 st (in millions) 2008 2009 2010 390 420 480 328 353 400 62 67 80 39. 8 43. 7 48 5 5 8 0 0 0 17. 2 18. 3 24 5. 5 5 7 11. 7 13. 3 17 4. 7 5. 3 6. 8 7 8 10. 2 2 5 2 6 3. 2 7
Managerial Balance Sheet TJX Distributors Cash WCR Net Fixed Assets Total Invested Capital Short Term Debt Long Term Debt Shareholders' Equity Total Capital Employed Managerial Balance Sheet December 31 st (in millions) 2008 6 59 56 121 2009 12 63 51 126 2010 8 77 53 138 15 42 64 121 22 34 70 126 23 38 77 138
Sustainable Growth Rate • If both owners' equity and debt increase by 10 percent, their sum, which is equal to the firm's invested capital, will also increase by 10 percent. • If the firm's capital turnover (sales divided by invested capital) does not change, sales will also increase by 10 percent. • This 10 percent growth in sales is TJX Distributors' self sustainable growth rate. • It is equal to the 10 percent growth in the firm's equity and is the fast estgrowth rate in sales the firm can achieve without changing its capital structure and operating policy and without raising new equity through a share issue. © Dr. C. Bulent Aybar
Generalization • From this example, we can now derive a general formula to compute the self sustainable growth rate ofany firm. • We define a firm's profit retention rate as the ratio of its addition to retained earnings to its earnings after tax: • Retention Ratio (R) = Addition to R/E (t)/Earnings (t 1, t) • The addition to R/E at time t ; Earnings (or Net Income or Profit After Tax) has been generated during period (t 1, t). • Then, the sustainable growth rate which is equal to the rate of increase in owners' equity, can be written as follows: SGR=Retained Earnings(t)/Equity(t 1) SGR=[Retention Ratio x Earnings (t)] /Equity(t 1) SGR=Retention Ratio x ROE © Dr. C. Bulent Aybar
New Sales New Assets Financing As the chart clearly shows, sales growth requires investment in assets; addition to R/E and an amount of debt that would preserve the debt equity ratio is used to finance these investments.
Sustainable Growth Rate “g*” • From the previous figure, the limit to growth is the rate at which equity expands. So focusing on equity expansion allows us to determine the SGR. • Therefore, g* is the ratio of the change in equity to equity at the beginning of the period. © Dr. C. Bulent Aybar
Plowback, ROE and SGR • If the firm pays out all of its earnings as dividends, it cannot grow its equity. • If R stands for the plowback ratio or (1 payout ratio), then g* is the product of R and return on equity. • g* = R x ROE. • g* = P x R x A x T or PRAT (as Higgins puts it) where T is assets/equity based on beginning of period equity, A is asset turnover, and P is profit margin.
Levers of Growth • The levers of growth here are PRAT. – g* is the only sustainable growth rate consistent with these ratios. – A company that grows too quickly might not be able to increase operating efficiency, and therefore resort to increased leverage. – That may increase distress costs and may create substantial disruptions.
Balanced Growth • ROA is Net income / Assets. • With this definition, g* is the product of (Rx. T) and ROA, where Rx. T reflects financial policy and ROA reflects operating performance.
TJX Sustainable Growth Rate and Actual Growth TJX Sustainable Growth Analysis: Year Retention Ratio ROE 2009 75. 00% 12. 50% 2010 68. 63% 14. 57% SGR 9. 38% 10. 00% Actual Growth Rate 7. 69% 14. 29% • The table above shows the firm's self sustainable growth rate in 2009 and 2010 (computed according to the equation we developed) and the growth in sales the firm experienced during these two years. • TJX Distributors' self sustainable growth rate was 10 percent in 2010, slightly higher than its value of 9. 4 percent a year earlier. Its sales, however, grew by 14. 3 percent during 2010, a rate almost twice that achieved the previous year (7. 7 percent). • How did TJX grow its sales by 14. 3 percent in 2010 with roughly the same self sustainable growth rate as in 2009 without issuing new shares? © Dr. C. Bulent Aybar
• In other words, where did the firm get the additional capital required to grow sales beyond the self sustainable growth rate of 10 percent? TJX Distributors • Managerial Balance Sheet December 31 st (in millions) 2008 2009 2010 Cash WCR Net Fixed Assets Total Invested Capital 6 59 56 121 12 63 51 126 8 77 53 138 Short Term Debt Long Term Debt Shareholders' Equity Total Capital Employed 15 42 64 121 22 34 70 126 23 38 77 138 The answer is f in TJX’s managerial balance sheet. Cash decreased from $12 million at the beginning of 2010 to $8 million at the end of that year, a one year drop of 33 percent. This means that TJX used its cash holdings to finance the gap between its self sustainable growth rate and its growth in sales. © Dr. C. Bulent Aybar
• This example illustrates an important point: – firms with sales growth >SGR will eventually experience a cash deficit; – firms with sales growth< SGR will eventu allygenerate a cash surplus. © Dr. C. Bulent Aybar
SGR, Actual Growth Funding and Investment Problems This phenomenon is illustrated in the chart. • Firms positioned on the line are in balance. Their SGR is equal to their growth in sales. • Firms with sales growth exceeding their SGR are above the line and they generate cash deficits and face a funding problem. • Firms with sales growth slower than their self-sustainable growth rate are below the line. They have cash surplus have an investment problem- they generate more cash than they can invest.
• How can management respond to unsustainable levels of growth in sales? • For example, suppose TJX expects its sales to grow by 15 percent next year. This growth rate is clearly unsustainable if TJX maintains its self sustainable growth rate at its current level of 10 percent • If raising new equity is not an option, then the management will have to make operating or financing decisions that will raise the firm's self sustainable growth rate to 15%. Otherwise, TJX will experience a continued loss of cash next year that may eventually face a funding and liquidity crisis. • © Dr. C. Bulent Aybar
• If we assume that next year's ROE will be the same as this year's (14. 6%), then one possi ble option is to retain 100 percent of the firm's profit. • With a retention rate of one, the firm's self sustainable growth rate will be equal to its ROE. • This option would raise the firm's self sustainable growth rate to 14. 6 percent, a figure close to the firm's 15 percent expected growth in sales. • However, since it implies an elimination of dividend payments, it is likely to upset shareholders, and it will probably trigger an negative reaction in the market. © Dr. C. Bulent Aybar
• Let's assume that TJX management is unwilling to cut dividends below 20 percent of profits, and want to maintain debt to equity ratio of one. • With these constraints, the firm's SGR can be increased only through an improvement in the firm 's operating profitability. • How much does TJX operating profitability, measured by its ROIC before tax need to increase to bring its SGR up to its target? © Dr. C. Bulent Aybar
• To achieve a target SGR of 15 percent with a retention rate of 80 percent, TJX’s Return on Equity should increase o 18. 7 percent. • SGR=Retention Ratio x ROE • SGR=15% = 0. 8 x ROE=18. 75% • To achieve 18. 75% ROE, what level of ROICBT should we reach? © Dr. C. Bulent Aybar
ROE and ROICBT • ROE=(EBIT/Sales) x (Sales/IC) x [(EBT/EBIT)x (IC/Equity)]x(EAT/EBT) • Where IC=Invested Capital or (Equity + Interest Bearing Debt) • ROE=Operating Margin x Capital Turnover x Financial Leverage Multiplier x Tax Effect Ratio • ROICBT= EBIT/IC • ROE= ROICBT x Financial Leverage Multiplier x Tax Effect Ratio • = ROICBT =ROE/(Financial Leverage Multiplier x Tax Effect Ratio) • ROICBT =18. 75%/[(138/70) x (17/24) x (10. 2/17)]=22. 38% • This means that TJX’s operating profitability should reach to 22. 4% • Since ROICBT =(EBIT/Sales)x(Sales/IC) we can achieve this either by increasing operating profitability or asset (capital) turnover or both! © Dr. C. Bulent Aybar
Capital Turnover • Let’s assume that we can improve the operating margin from 5% to 5. 5%. • What should be then the capital turnover ratio? • Since ROICBT =(EBIT/Sales)x(Sales/IC) • 22. 38%=(5. 5%)/Capital Turnover • Capital Turnover=4. 07 ~ 4 © Dr. C. Bulent Aybar
Prospects for TJX • How can this objective be achieved? The operations manager will have to focus first on the firm's WCR; receivables will have to be collected faster and inventories will have to turn over as quickly as possible. • Being in the distribution business, however, TJX uses a relatively small amount of fixed assets, and thus has a lower opportunity to rapidly improve its fixed asset turnover ratio (sales divided by fixed assets). • This challenge suggests that it is difficult for TJX to increase its SGR to 15% without raising new equity. • Given company’s financial constraints, if the firm's management cannot achieve the targeted improvements in the firm's operations, the firm's owners will have to inject new equity into the business, issue new shares, or accept lower than expected sales. © Dr. C. Bulent Aybar
What To Do When Actual Growth Exceeds Sustainable Growth? – Sell new equity – Increase financial leverage – Reduce dividend payout – Divest marginal activities – Increase prices – Merge with a “cash cow” © Dr. C. Bulent Aybar
Too Little Growth? • What to do with the profits? – In a couple of slides Jos. A. Bank Clothiers is examined! • Before that, the next slide displays the overall pattern in respect to how companies finance themselves.
Sources of Capital to U. S. Nonfinancial Corporations, 2001— 2010
A Sustainable Growth Analysis of Jos. A. Bank Clothiers, 2006— 2010
What Did Jos. A. Bank Clothiers Do? • Reduced financial leverage • Sat on the money • In the next slide, what do you see about clustering of growth rates and returns? • What do you think the company should be thinking about next? © Dr. C. Bulent Aybar
Jos. A. Bank Clothiers, Inc. Sustanable Growth Challenges, 2006— 2010
Actual sales growth above a firm’s SGR • Is not necessarily good for shareholders. It causes one or more of the defining ratios to change. • Must be anticipated and planned for. It can be managed by – Increasing financial leverage. – Reducing the dividend payout ratio. – Pruning away marginal activities, products or customers. – Outsourcing some or all of production. – Increasing prices. – Merging with a “cash cow. ” – Selling new equity. © Dr. C. Bulent Aybar
Value of Different Type of Growth Source: Four Cornerstones of Value, Mc. Kinsey Consulting
Actual sales growth below a firm’s SGR • Generates excess cash that can expose firm as a takeover target. • Forces management to find productive uses for the excess cash, such as – Reducing financial leverage; – Returning the money to shareholders: increasing payout ratio or repurchasing stocks. – Cutting prices; – “Buying growth” by acquiring rapidly growing firms in need of cash. © Dr. C. Bulent Aybar
New Equity • American companies for most of the past 25 years have retired more equity than they have issued. • Equity is an important source of cash to a number of smaller, rapidly growing companies with high growth prospects. • It is used cautiously because – Companies in the aggregate have not needed the additional cash. – Issue costs of equity are high relative to those of debt. – New equity tends to reduce earnings per share, something most managers try to avoid – Managers commonly believe their current share price is unreasonably low and they can get a better price by waiting. © Dr. C. Bulent Aybar
Gross Proceeds • 30 year average = $98. 3 b • High $234 b in 2009 • Spike at end from banks who were frantically raising new equity to survive • Gross proceeds from new stock for nonfinancial corporations equaled 4% of total sources of capital • Relative to external sources, the number was 11. 6%
Why Don’t US Companies Issue More Equity? • Other sources generated sufficient cash • Equity is expensive to issue (flotation) • Fear of diluting EPS in the short run • Concern that their stock is undervalued in the market • Windows close © Dr. C. Bulent Aybar
Cost of Issuing Equity Source: Butler et. al (2005) “Stock Market Liquidity and the Cost of Issuing Equity”, Journal of Financial and Quantitative Analysis
Gross New Stock Issues by Corporations and IPOs, 1980— 2010
Gross Equity Issues in the US US Equity Issues 2003 -2013 IPOs and Seasoned Issues as well as Preferred Shares 350. 00 300. 00 250. 00 200. 00 150. 00 100. 00 50. 00 Total Gross Equity Issues True IPOs 20 13 20 12 20 11 20 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 -
Global Equity Issues
IPO Volume Shifted to EMs
Quarterly Stock Repurchases
High Growth • High Growth is not the norm. A recent study by Mc. Grath 1 asked the following question: • “How many publicly traded companies with a market capitalization of at least US$1 billion grew by 5% each year for five years ending with 2009? “ • She found that only 8% of the 4, 793 companies in her sample grew their revenues by at least 5% year after year, and only 4% achieved a net income growth of at least 5% in each of the five year • When she increased period to 10 years, she found out that only 10 companies out of 2, 347 could achieve net income growth of 5%, and only 5 improved revenues and profits each year. Rita Gunther Mc. Grath Harvard Business Review January – February 2012 © Dr. C. Bulent Aybar
Blinded by Growth (Javier Estrada, JACF 2012) • The analysis of growth have shown that firms can go broke by growing! • Even high growth companies that look good, do not deliver much to their shareholders: © Dr. C. Bulent Aybar
Google and Amazon • Google’s corporate performance, as measured by its earnings growth of over 40% a year, was spectacular. However from 2006 to 2010 Google investors earned an annualized return of just 1. 6% (or a holding period return of just 7. 3%, when earnings grew over 358%. ) • From July 2004 through the end of 2008, Amazon grew its earnings by 130. 8%, or at an annualized rate of 20. 4%. However investors realized a holding period negative return of 5. 7%, losing money at the annualized rate of 1. 3%. © Dr. C. Bulent Aybar
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