We have done plenty of analysis in parts one, two, and three. Now we are going to take it a step further. This section is going to focus on the company’s financial structure. More specifically, we are going to take a look at how the company is going to finance its expected growth. This is important to understand as it measures a company’s ability to increase earnings within its existing financial structure. As a reminder, we will be using hypothetical stock “ABC” as our model company.
Part 4 – Financial Structure Analysis
Each firm develops a financial plan which details how its financial goals are to be achieved. A company’s financial structure refers to the mix of long-term debt and equity the company uses to finance operations.
There are two main ways that a firm can fund growth. It can generate sufficient funds internally or it must access external financing. Furthermore there are two main types of external financing; debt and equity. Both will have different impacts on a company’s share price. For example, a company that is highly indebted may have to issue new shares to fund growth. This will typically have a negative impact on shares. Investors can inform themselves by taking the company’s financial policy as fixed and subsequently examine the company’s ability to fund its expected growth.
Here are three quick criteria for investors to use:
- Internal Growth Rate (IGR): The internal growth rate of the company is the growth that the company can achieve without any external financing. To calculate the IGR, investors will need the company’s return on assets (ROA) and its plowback (R) ratio. The plowback ratio is the portion of earnings re-invested into the company and is equal to 1-dividend payout ratio. As a reminder, the dividend payout ratio is achieved by dividing the total dividends paid by net income, or dividend per share (DPS) by earnings per share (EPS). It is important to note that many high growth companies will have very low or negative IGRs.Criteria – IGR > Expected Earnings Growth Rate
IGR = (ROA * R)/1-ROA * R
Revisiting our example of stock ABC, its ROA is 8.72% and its dividend payout ratio is 28.12%. As a result we can calculate the following:
R = 1-0.2812 = 0.7188
IGR = (0.0872* 0.7188)/1-0.0872*0.7188
IGR = 0.0669 or 6.69%
As you can see, the company’s IGR of 6.69% is below its expected growth forecasts of 28.5% as identified in Step 2. This means that the company can grow at a rate of 6.69% without issuing more stock or taking on more debt. As a result, it will need some type of external financing to achieve its expected growth rate.
- Sustainable Growth Rate (SGR): Now that we have established that the company will require external financing, let’s take a look at the company’s SGR. The SGR is the rate at which the company can grow and maintain its existing financial structure. It assumes that the company will maintain its existing financial leverage and that debt to equity ratio will remain constant. The SGR calculation is very similar to that of IGR, except that it swaps out ROA for return on equity (ROE).Criteria – IGR > Earnings Growth Rate
SGR = (ROE * R)/1-ROE * R
Revisiting our example of stock ABC, its ROE is 17.03% and its dividend payout ratio is 28.12%. As a result we can calculate the following:
R = 1-0.2812 = 0.7188
SGR = (0.173 * 0.7188)/1-0.173*0.7188
SGR = 14.2%
Once again, the company’s SGR of 17.03% is below the company’s expected growth rate of 28.5%. As a result, the company will have to alter its existing capital structure to reach the growth targets. This can be done in a variety of ways. It can increase its financial leverage by issuing more debt, reduce its dividend payout ratio, increase profit margins, issue additional stock, or it can use a combination of any of these.
- Leverage ratio: If the company’s SGR is not sufficient to fund expected growth, investors should take a look at the company’s debt to equity (D/E) ratio. A company with high leverage may be forced to issue equity which will have a negative impact on its share price. In this case, the share price drops because it reveals that the company has too much debt, and dilutes current shareholder equity in the firm. On the flip side, a company with low leverage is preferable as it is better positioned to raise debt, and at lower costs. In order to determine if a company’s leverage is acceptable, we compare its debt/equity ratio to industry averages.Criteria – D/E < Industry Average
If you’ll remember, we already examined this ratio and compared it to the industry in Step 3. In our example, stock ABC had a D/E ratio of 59.08% which was significantly below the industry average of 74.01%. As a result, we can assume that the company can comfortably tap into the debt market without having to issue equity.
Had Stock ABC’s leverage ratio been significantly above industry averages, we could conclude that the company would have a harder time accessing the debt market and could potentially require an equity issue.
Where to access the data?
A company’s D/E, ROE, ROA and dividend payout ratios can easily be found on most financial websites, including discount brokers. The plowback ratio, IGR, and SGR will most likely need to be calculated.