June 6, 2015

Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Self-Sustainable Growth Rate (SSGR) is the rate of growth, which a company can achieve from its profits without relying on additional sources like debt or equity dilution. SSGR estimation has occupied an important part of my stock analysis as it indicates the strength of the business model of a company. 

A company with high self-sustainable growth rate can continue to show high growth rates without impairing its capital structure, i.e. without raising high debt. I believe that the growth funded by profits is the best form of growth as it keeps the company insulated from many adverse factors during tough economic environments.

Debt has a high cost attached to it. The interest eats into the profitability. Interest and principal needs to be paid as per agreed schedule irrespective of the company generating profits or not. This increases the risk of bankruptcy during tough times. 

The shareholders of debt-free companies can sleep easy at night irrespective of the company facing economic headwinds or tailwinds. Debt-free companies have the leeway of reducing prices, dividend payouts and even suffer losses for a longer period than debt-laden companies. Therefore, debt free companies have higher probability of coming out successful from economic downturns and provide avenues of long-term growth to investors at lower risk.

Self-Sustainable Growth Rate (SSGR) is one such parameter that can help an investor determine, which companies would be able to show debt free growth in future. The investor can then study further about these companies and post detailed analysis, she can shortlist companies for investment. The investor, convinced with detailed financial, business, management & valuation analysis and high SSGR, can keep the invested companies in her portfolio with confidence.

I thank my friend, Saurabh Dwivedi, a sea-surfer turned banker, for providing his valuable time & inputs where after multiple rounds of discussions & iterations, we could bring the self-sustainable growth rate (SSGR) formula to the implementation stage.

Self-Sustainable Growth Rate

 


Self-sustainable growth rate derives its genesis from the basic outline of a company’s growth story. During its life, a company needs to:
  1. Sell products in the market
  2. Generate profits from these sales
  3. Pay dividends from its profits
  4. Invest undistributed profits in company’s assets
  5. Use these assets to produce sales in the future
A company needs to do these activities year on year for long periods. If the company were able to do it successfully, then it would generate huge amount of wealth for its shareholders.

Efficiency level of any company on the steps discussed above can be easily assessed by readily available information in public domain:
  1. Net Profit Margin (NPM): NPM highlights the ability of the company to generate profits from sales.
  2. Dividend Payout Ratio (DPR): DPR indicates the share of profits that is distributed as dividends to shareholders. (1-DPR) reflects the share of profits retained by the company for reinvestment in its own operations. 
  3. Depreciation (Dep): Depreciation indicates the wear & tear of a company’s assets over time. It is an indicator of reduced efficiency of existing assets to produce sales as these assets become older.
  4. Net Fixed Assets Turnover (NFAT): NFAT provides the sales generation ability of a company from its net fixed assets. (net fixed assets = gross fixed assets – depreciation)
If an investor analyses the combined effect the four parameters discussed above, then she would be able to arrive at the expected growth rate of a company by utilizing only the retained profits. This expected growth rate is Self-Sustainable Growth Rate (SSGR).

The central theme of self-sustainable growth rate calculation is to first, find out the amount of funds available for reinvestment and then, the efficiency level with which these invested funds are utilized by the company. We can understand it by the elaboration given below:
  • Funds available for reinvestment (Reinvest-able funds) = (Sales in Year ‘0’)*NPM*(1-DPR)
  • Fixed assets at end of the year ‘0’/start of year ‘1’ = Fixed assets at start of year ‘0’ – Depreciation + Reinvest-able funds
  • Sales expected in next year (Year ‘1’) = Fixed assets at end of year ‘0’ * NFAT 
  • Self-sustainable growth rate (SSGR) in % = (Sales in Year ‘1’ / Sales in Year ‘0’)-1

Using the understanding of SSGR as discussed above and some simple algebraic operations, the formula of SSGR calculation is reduced to the following equation:


SSGR = [(1-Dep) + NFAT*NPM*(1-DPR)] - 1


Where,
  • SSGR = Self Sustainable Growth Rate in %
  • Dep = Depreciation rate as a % of net fixed assets
  • NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
  • NPM = Net profit margin as % of sales
  • DPR = Dividend paid as % of net profit after tax

The Self-Sustainable Growth Rate (SSGR) formula is a simplified one, because:
  1. All the input ratios like NPM, Depreciation, Dividend Payout, Fixed Asset Turnover keep on changing year after year and huge variation in any one year can significantly alter the SSGR output.
  2. The formula assumes that profits reinvested in any year get converted in to fixed assets in the same year and start generating sales from next year. However, in reality any capital expenditure (capex) done by a company would take a few months or years to become operational in form of increased production capacity.
  3. The formula does not factor in an important parameter where funds are locked in or released during the year, which is working capital.

Out of the three points highlighted above, first two can be mitigated by taking average of last 3-year data of all the ratios i.e. NPM, Depreciation, Dividend Payout and Net Fixed Asset Turnover. Taking average will reduce the impact of any single year abnormal high/low value. Simultaneously, it will also ensure that the impact of reinvested profits of each year get distributed over 3 years, which is a reasonable period for any company to operationalize new capex into enhanced capacity.  

Important: I have used the 3-year average of all the ratios for the cases discussed in the illustrations below.

Regarding the third point of funds being locked in/released from working capital, an investor can find the evidence from comparison of cumulative net profit after tax (cPAT) of last 10 years with the cash flow from operations (cCFO) over the same period. Based on her case specific findings, the investor can adjust her interpretation of SSGR outcome to reflect the reality. We would discuss some of such cases in the interpretation section below.

Interpretations

 


A) If Self-Sustainable Growth Rate (SSGR) is more than the sales growth of the company.

 

It indicates that the company has the ability to generate cash in excess of the requirement to sustain its current growth rate. Such companies usually keep on accumulating cash, can afford to give high dividends without impacting prospects of future growth or can increase their growth rate in future without straining their capital structure. 

We can see examples of a few companies that have their self-sustainable growth rate (SSGR) more than their current growth rates.

FDC Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

The self-sustainable growth rate (SSGR) of FDC Limited is about 30-40%. However, the company has been growing at about 8-10% over last 10 years. Comparison of past sales growth with SSGR would indicate that its entire growth could be funded by its profits. An investor can notice that FDC Limited has very low & almost nil debt on its books.

Container Corporation of India Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

We can see that the self-sustainable growth rate (SSGR) of Container Corporation of India Limited is about 22-25%. However, the company has been growing at about 8-11% over last 10 years. Comparison of past sales growth with SSGR would indicate that it could fund its entire growth by its profits. No wonder that Container Corporation of India Limited is a debt free company.

Hindustan Unilever Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

The self-sustainable growth rate (SSGR) of Hindustan Unilever Limited is about 40% whereas its sales growth has been 12% over last 10 years. The result is that Hindustan Unilever Limited is a debt free company because it could fund its growth by its profits without relying on additional debt.

Thus we can see that the companies with SSGR higher than past sales growth are either debt free or have reduced their debt significantly over past. These companies are good investment candidates as they can keep growing without need of debt and can face tough economic situations better.

 

B) If Self-Sustainable Growth Rate (SSGR) is less than the sales growth shown by the company in the past:

 

Such a situation will indicate that the company’s business model does not have the inherent strength to sustain the growth rate it is trying to achieve. The company would continuously need to supplement its profits by bringing in additional cash from equity infusion or debt, to fund its growth aspirations. Most of such companies rely primarily on debt to meet the requirement of additional cash and thereby see high levels of debt on their balance sheets.

Let us see examples of a few companies that are growing at a rate higher than their self-sustainable grother rate (SSGR). 

Castex Technologies Limited (erstwhile Amtek India Limited):

Self Sustainable Growth Rate Debt free growth potential Amtek India limited Equity Analysis Research Report


We can see from the above data that the self-sustainable growth rate (SSGR) of Amtek India Limited is very low, almost 0-1%. This is primarily because of very low fixed asset turnover of 0.6-0.7. Low SSGR indicates that almost entire sales growth of 25-30% in the past has been debt funded. There is little surprise left in the observation that the debt of Amtek India Limited has increased from INR 156 cr. to INR 5,186 cr. over last 10 years. 

You may read further about Amtek India Limited in the following article:



Metalyst Forgings Limited (erstwhile Ahmednagar Forgings Limited)

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

We can see that the self-sustainable growth rate (SSGR) of Ahmednagar Forgings Limited is about 5-6%. However, the company has been growing at about 30-35% over last 10 years. Comparison of past sales growth with SSGR would indicate that the excess sales growth of 25-30% in the past has been funded by debt. Therefore, the debt of Ahmednagar Forgings Limited has increased from INR 62 cr. to INR 2,092 cr. over last 10 years. 

You may read further about Ahmednagar Forgings Limited in the following article:



Glenmark Pharmaceuticals Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

We can see that the self-sustainable growth rate (SSGR) of Glenmark Pharmaceuticals Limited is about 15-18%. However, the company has been growing at about 25-30% over last 10 years. It indicates that the excess sales growth of 8-10% in the past has been funded by debt. Therefore, the debt of Glenmark Pharmaceuticals Limited has increased from INR 437 cr. to INR 3,267 cr. over last 10 years.

Polyplex Corporation Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

We can see that the self-sustainable growth rate (SSGR) of Polyplex Corporation Limited is lower than its sales growth over last 10 years. Therefore, the debt of Polyplex Corporation Limited has increased from INR 100 cr. to INR 1,821 cr. over last 10 years. It has reported losses in FY2014 when it had to pay interest of about INR 200 cr. to lenders for its debt of INR 1,821 cr. (assuming interest rate of about 11%).

You may read further about Polyplex Corporation Limited in the following article:



We can see that for all these companies, which are trying to grow at a pace faster than their inherent self-sustainable growth rate (SSGR), their debt levels are spiraling in an attempt to provide funds needed to produce the excess growth. The debt-funded growth exposes the company and its shareholders to high risk of reduced profitability and bankruptcy during tough economic situations.

 

C) Companies that have SSGR less than current growth rate, but still manage to reduce debt over the years.

 

Ideally, companies with self-sustainable growth rate (SSGR) less than current growth rate are expected to see high debt levels as seen in the above discussion. It is with the assumption that such companies do not generate sufficient funds from their profits to meet the requirements of growth. However, an investor would come across companies where despite low self-sustainable growth rate (SSGR), the companies have reduced their debt levels. 

In most of these companies, the investor would find that the companies have improved their operating efficiency over the years or have sold their assets to generate cash to repay debt.

Improved operating efficiency would release funds stuck in working capital either in the form of inventory or receivables. Increasing inventory turnover or decreasing receivables days lead to funds stuck in working capital being released. It would be evident from cCFO of last 10 years being higher than cPAT over the same period.

Funds raised from sales of the assets would appear as positive cash from CFI (cash flow from investing).

We can see the example of Fiem Industries Limited, which has SSGR lower than current growth rate. Nevertheless, it has been able to reduce its debt by improving its operating efficiency.

Fiem Industries Limited

Self Sustainable Growth Rate Debt free growth potential FDC limited Equity Analysis Research Report

We can see that the self-sustainable growth rate (SSGR) of Fiem Industries Limited is about 1-2%. However, the company has been growing at about 25% over last 10 years. Comparison of past sales growth with SSGR would indicate that the excess sales growth should have been funded by debt. It has been true in the past as we can see that the debt levels of Fiem Industries Limited has increased from INR 23 cr. in FY2005 to INR 139 cr. in FY2012

However, the improved inventory turnover in recent years from 12.0 to 15.8 has released the capital stuck in working capital. This has led to the generation of excess cash by way of cCFO over last 2 years of INR 148 cr. (71+77) than cPAT of INR 64 cr. (27+37) over same period. The cash released from working capital could be used by the company to reduce its debt over last 2 years from INR 139 cr. to INR 87 cr.

You may read further about Fiem Industries Limited in the following article:



An investor should be cautious while investing in such companies, as their inherent business model cannot sustain high growth rates they are trying to achieve. Debt reduction is mainly due to improving efficiency. Debt levels are expected to rise, when these companies reach optimal level of operating efficiency and are not able to reduce working capital further or do not have further non-core assets to sell.

 

D) If SSGR is similar to current growth rate of the company

 

In such companies, the investor needs to see whether the entire profits are available for fixed asset creation or are being stuck in working capital. A simple test to find this out is by comparing the cumulative net profit after tax (cPAT) of last 10 years with the cash flow from operations (cCFO) over the same period. 

If cCFO, which factors in changes in the working capital, were significantly less than cPAT, then it would indicate that the company would not be able to maintain its current growth rate without raising additional funds. Otherwise, the company would need to raise additional cash by either equity or debt to fund its increased working capital needs along with growth.

Conclusion

 

We can see that the companies, which have high Self-Sustainable Growth Rate (SSGR), are able to grow in a debt-free manner and provide good wealth creation opportunities for shareholders.

High Self-Sustainable Growth Rate (SSGR) is dependent upon below factors:
  1. High net profit margins (NPM)
  2. Low dividend payout ratio (DPR)
  3. Low depreciation (Dep)
  4. High net fixed asset turnover (NFAT)
Therefore, a company that currently has low Self-Sustainable Growth Rate (SSGR), can improve its SSGR by:
  1. Improving its profitability (NPM) so that it generates higher funds by profits
  2. Reducing dividend payouts so that most of the profits are reinvested in company’s operations
  3. Increase net fixed asset turnover (NFAT) by using better technology & processes so that it can produce more sales from same amount of fixed assets.
I believe that an investor should invest in companies, which have nil or very low debt on their books. Such companies are easy to find by filtering all the stocks on debt to equity parameter. However, the ideal investments are the stocks, which can remain debt-free when they grow in future. The investor can find such stocks by analyzing the Self-Sustainable Growth Rate (SSGR) during detailed analysis.

This brings us to the end of this article in which we learned about assessing the inherent growth capabilities of companies. We noticed that companies trying to grow at a higher rate than the self-sustainable growth rate (SSGR) end up having a lot of debt on their balance sheet. Such companies expose the shareholders to high risk. On the other hand, if companies having self-sustainable growth rate (SSGR) higher than current growth rate, then they can keep on growing without raising debt and provide good long-term investment opportunities for investors.

Addendum (June 13, 2015)

 

As requested by many readers about the steps used by me for arrival of the SSGR values in the data tables above, I have enlisted the steps below.

To get the values of SSGR calculated by me, a reader would need to calculate:
  • Dep = Average level of Depreciation as % of NFA for preceding three years
  • NFAT =  Two steps 
    • Fiirst calculate the NFAT for any year = sales for the year/(average of NFA at start and end of year),
    • Then, take average NFAT for preceding three year for putting into SSGR formula
  • NPM = Average NPM of preceding three years
  • DPR = Average DPR of preceding three years

After putting these values in the SSGR formula a reader would get the values of SSGR calculated by me.

Over time, readers have asked various queries related to multiple aspects of Self Sustainable Growth Rate (SSGR) including its similarities and differences with other popular ratios like return on equity (ROE), return on capital employed (ROCE) etc. I have compiled these queries and their responses in the following articles so that other readers can also benefit from them:



Your Turn:

 

I would like to know whether you use the sustainable growth rate as an investment criterion. If yes, then which parameters you use to find out the sustainable growth rates for companies. If no, then what are the other criteria you use to determine probabilities of consistent healthy growth in future? Your inputs would help the author and the other readers of the website; improve their understanding of stock analysis. You may write your inputs in the comments below or contact me.

P.S. I have used the financial data provided by screener.in while conducting analysis for this article.


DISCLAIMER

 


The views and opinions expressed or implied herein are my own and do not reflect those of my employer, who shall not be liable for any action that may result as a consequence of my views and opinions.

Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013, since May 25, 2016.

Details of Financial Interest in the Subject Company:


Currently, I do not own stocks of any of the companies discussed above. I have disclosed stocks in my portfolio on a dedicated page (My Portfolio). I request you to see the list of stocks I own, because it is assumed that my views can be biased when I opine about any stock which I own and therefore, have a financial interest.