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Earnings growth is what fuels aggressive growth stocks. Therefore, it is of utmost importance that investors to have an idea how long a company can sustain a certain level of earnings growth. The company's valuation and thus the stock price is almost completely dependent on this fact.
So how is an investor to know how long earnings growth can last? An easy way to gauge this is by calculating the company's sustainable growth rate.
The sustainable growth rate can be calculated by multiplying a company's return on equity (ROE) by its earnings retention ratio (1- dividend payout ratio).
So, Sustainable Growth Rate = Return on Equity x (1 - Dividend Payout Ratio).
This ratio is important is it tells us how quickly a company can grow with internally generated funds. Without this growth, a firm will have to issue more shares or tap the debt markets for more capital. This will dilute the shares and cause the stock to go lower.
For example, let’s assume XYZ Inc. has an impressive ROE of
53% and a dividend payout ratio of 27%. It’s sustainable growth rate would be .53 x (1 -.27) = 38.69%.
The calculation tells us that XYZ can keep up that growth rate without seeking external sources of equity. It doesn't mean that it will grow at that rate forever. Rather, it is likely that as the company matures even more, the payout ratio will rise as XYZ’s ability to generate growth slows down.
Going back to the formula, it is apparent that a company's sustainable growth rate would equal its ROE if there is no dividend. Most aggressive growth stocks that are still in their young stages do not pay a dividend, so keep a close eye on the ROE.
(Both the ROE and the dividend payout for any company can be found in the Full Company Report. Just call up a quote for any stock and then click on “Company Reports” which is located just above the company’s name on the quote page.)
Conclusion
The last thing you want as a shareholder in an aggressive growth company is to be victimized by a secondary offering. This event can significantly dilute your shares and make you lose serious money. Now you have a tool to determine whether or not your company can grow without having to resort to external equity.
