Sustainable growth rate


According to PIMS, an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, market growth, marketing expense to sales ratio or a strong market position.
The question how much growth is sustainable is answered by two concepts with different perspectives:
The sustainable growth rate is the growth rate in profits that a company can reasonably achieve, consistent with its established financial policy.
An assumption re the company's sustainable growth rate is a required input to several valuation models—for instance the Gordon model and other discounted cash flow models—where this is used in the calculation of continuing or terminal value; see Valuation using discounted cash flows.
Several formulae are available here.
In general, these link long term profitability targets, dividend policy, and capital structure assumptions, returning the sustainable, long-run business growth-rate attainable as a function of these. These formulae reflect the general requirement that all assumptions are internally consistent; see.
A check on the formula inputs, and on the resultant growth number, is provided by a respective twofold economic argument.
The microeconomic argument: Where the Return on capital is significantly higher than achievable in other industries, then this success will attract competition; in the long-run then, the company's returns will tend to those of its industry, in turn tending to the economy; see Profit. Formulae inputs - i.e. assumed profit as compared to targeted capital structure - must be limited correspondingly.
The macroeconomic check: The long-run growth of the company cannot exceed overall economic growth by any significant amount - otherwise the company in question would eventually constitute the bulk of the economy; see. A calculated growth rate, where the given assumptions are input to a growth formula, can then also act a check as to whether budgets or business plans are reasonable.
The sustainable growth rate may be returned via the following formula:
Note that the model presented here, assumes several simplifications:
the profit margin remains stable;
the proportion of assets and sales remains stable;
related, the value of existing assets is maintained after depreciation;
the company maintains its current capital structure and dividend payout policy.

Optimal growth rates from a total shareholder value creation and profitability perspective

Optimal growth according to Martin Handschuh, Hannes Lösch and Björn Heyden is the growth rate which assures sustainable company development – considering the long-term relationship between revenue growth, total shareholder value creation and profitability.
Assessment basis: The work is based on assessments on the performance of more than 3500 stock-listed companies with an initial revenue of greater 250 million Euro globally and across industries over a period of 12 years from 1997 till 2009. Due to this long time period, the authors consider their findings as to a large extent independent of specific economic cycles.

Relationship between revenue growth, total shareholder value creation and profitability

In the long-term and across industries, total shareholder value creation rises steadily with increasing revenue growth rates. The more long-term revenue growth companies realize, the more investors appreciate this and the more they get rewarded.
Return on assets, return on sales and return on equity do rise with increasing revenue growth up to 10 to 25% and then fall with further increasing revenue growth rates.
Also the combined ROX-index shows rises with increasing growth rates to a broad maximum in the range of 10 to 25% revenue growth per year and falls towards higher growth rates.
The authors attribute the continuous profitability increase towards the maximum of two effects:
  1. Profitability drives growth: Companies with substantial profitability have the opportunity to invest more in additional growth.
  2. Growth drives profitability: Substantial growth may be a driver for additional profitability, e.g. by higher attractiveness for high performing young professionals, higher employee motivation, higher attractiveness for business partners as well as higher self-confidence.
Beyond the profitability maximum extra efforts to handle additional growth – e.g. based on integrating new staff in large dimensions and handling culture and quality - do rise sharply and reduce overall profitability.
The combination of the patterns of revenue growth, total shareholder value creation and profitability indicates three growth zones:
Growth rates of the assessed companies are widely independent of initial company size/ market share which is in alignment with Gibrat's law. Gibrat's law, sometimes called Gibrat's rule of proportionate growth is a rule defined by Robert Gibrat stating that the size of a firm and its growth rate are independent.
Independent of industry consolidation and industry growth rate, companies in many industries with growth rates in the range of 10 to 25% revenue growth p.a. have both, higher total shareholder value generation as well as profitability than their slower growing peers.

Base strategies and growth moves

These findings do suggest two base strategies for companies:
The authors have identified a set of preconditions and levers to achieve long-term growth in their defined sweet-spot and beyond:

Preconditions

As described the sustainable growth rate concept by Robert C. Higgins is based on several assumptions such as constant profit margin, constant debt to equity ratio or constant asset to sales ratio. Therefore, general applicability of SGR concept in cases where these parameters are not stable is limited.
The Optimal Growth concept by Martin Handschuh, Hannes Lösch, Björn Heyden et al. has no restrictions to certain strategies or business model and is therefore more flexible in its applicability. However, as a broad framework, it only provides an orientation for case/company specific mid- to long-term growth target setting. Additional company and market specific considerations, e.g. market growth, growth culture, appetite for change, are required to come up with the optimal growth rate of a specific company.
Additionally, considering the increasing criticism of excessive growth and shareholder value orientation by philosophers, economists and also managers, e.g. Stéphane Hessel, Kenneth Boulding, Jack Welch, one might expect that investors' investment criteria might also change in the future. This may lead to changes in the relationship of revenue growth rates and total shareholder value creation. Regular reviews of the optimal growth assessments may be used as an indicator for the development of stock markets` appetite for rapid growth.