1. Sustainable Growth Rate

Formula 7.40

G = RR * ROE

Where:
RR = retention rate = % of total net income reinvested in the company
or, RR = 1 - (dividend declared / net income)

ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends.

Therefore, Dividend Payout = Dividend Declared/Net Income

Look Out!

Students sometimes confuse retention rate with actual dividend declared. Students should read questions diligently.

Let's consider an example:

Segment Analysis

Segment analysis requires conducting ratio analysis on any operating segment that accounts for more than 10% of a company's revenues or total assets, or that is easily distinguishable from the other company business in terms of products provided or the risk/return profile of the segment. Lines of business are often broken down into geographical segments, when the size or type of business differentiates them from other business lines.
Since many segments have different risk profiles, they should be analyzed and valued separately from other parts of the business. Conducting ratio analysis, specifically profit margins, return on assets and other profitability measures can give analysts insight into how the segment affects overall financial performance. Both U.S. GAAP and IFRS require companies to report specific segment data, which is only a subset of the overall reporting requirements.

Ratio Analysis

Ratio analysis can be used to estimate future performance and allows analysts to create pro forma financial statements. Here is one example of how to estimate the future earnings potential of a firm. An analyst can first create a common-size income statement by dividing all accounting items by total sales. Using forecast assumptions the analyst then determines the amount of future sales. By multiplying the common-size percentages by the new sales amount, the analyst prepares a pro forma income statement that estimates the future earnings potential based on the expectations of future sales.

By using a range of values from the common-size statement and using a range of values for sales, the analyst can conduct a sensitivity analysis for each of the accounting items, such as cost of goods sold (COGS), profit margin and net income, to see how sensitive they are to changes in the amount of sales.

By understanding how each of these items correlate to the changes in sales, an analyst can create a function that provides output for these measures for any potential sales amount in the future. Using this function an analyst can conduct scenario analysis by choosing assumptions for different market situations and create for example a base case, upside and downside scenario.

Scenario analysis gives analysts an idea of the risks involved in operating a firm under different economic situations. To create an even more detailed probability distribution of potential values and risk, some analysts will conduct simulations that use a computer to produce many potential scenarios

Return on Equity and the Dupont System

Related Articles
  1. Investing

    Payout Ratio vs. Retention Ratio: When to Use Which

    The payback ratio and retention ratio collect different information and are useful in different situations.
  2. Investing

    Corporate Dividend Payouts And the Retention Ratio

    An investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
  3. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  4. Investing

    4 Ratios to Evaluate Dividend Stocks

    Discover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
  5. Managing Wealth

    Looking Deeper Into Capital Allocation

    Discover how companies decide how to spend their cash in a variety of market conditions.
  6. Managing Wealth

    Understanding the DuPont Analysis

    DuPont analysis measures assets at their gross book value, rather than at net book value, in order to produce a higher return on equity (ROE).
  7. Investing

    How Return On Equity Can Help You Find Profitable Stocks

    It pays to invest in companies that generate profits more efficiently than their rivals. This is where ROE comes in.
  8. Investing

    Scenario Analysis Provides Glimpse Of Portfolio Potential

    This statistical method estimates how far a stock might fall in a worst-case scenario.
  9. Investing

    Ratio Analysis Tutorial

    If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
Frequently Asked Questions
  1. What's considered to be a good debt-to-income (DTI) ratio?

    Your debt-to-income ratio helps lenders determine your credit worthiness. Find out how to calculate your score and how to ...
  2. What is the difference between a loan and a line of credit?

    Learn to differentiate between lines of credit and standard loans, and determine when you are likely to use each method of ...
  3. What does a Chief Financial Officer (CFO) do?

    A CFO is responsible for accurate reporting of a company's financial information, investing the company's money and identifying ...
  4. How did George Soros break the Bank of England?

    George Soros pocketed $1 billion by betting against the British pound, cementing his reputation as the premier currency speculator ...
Trading Center