Friday, July 8, 2016

Projected Growth Rate: How to Estimate Your Earnings

The Cambridge Dictionary defines ‘projected growth rate’ as the estimated pace at which something will be growing in the foreseeable future. It’s a generous definition, as is apparent—one that applies equally well to macroeconomics (GDP projected growth rate) and corporate finance (dividend projected growth rate).
For the purposes of this post, we’ll be looking at various formulas and terms employed to calculate projected growth rates for company sales and dividends. We’ll be looking both at growth in terms of percentages, as well as at real dollars, and use previous performances to help you get to an accurate a guesstimate as possible.

projected growth rate of U.S. e-commerce activities
Image source: D. Steven White
While you read this article on projected growth rate definitions, formulas, and calculators, remember that they can only ever be guesses. They are based on assumptions, regarding new customers, potential costs, and annualized growth rates. Any projections regarding your earnings should allow for a certain amount of inaccuracies.

The growth rate formula for company sales

Why would an investor care about projected annual sales growth? Well, simply put, it’s because that’s where it all starts, for you as a stakeholder. If the company doesn’t manage to do well in terms of sales, there’s a very solid chance its revenue will drop and, with it, your profitable dividends.
So, here’s how you calculate the projected growth rate for annual sales:
formula for calculating projeted growth rate of sales
Companies file their sales for the previous year in their annual financial statements. So, then, let’s focus on next year’s sales. Check out the following example:
Company A made $1 billion in revenue last year. The company’s own projections for sales growth next year come down to 8%, which pegs next year’s sales at $1.08 billion. But let’s take the assumption even further and break it down to get a more detailed picture.
Let’s presume the company knows it’s going to add 10 accounts next year. Should clients continue to buy at the same pace they did last year, this spells out a $200 boost in revenue. That’s $1.2 billion in earnings next year—or a 20% projected growth rate in sales.
This formula is important, because it’s a good yardstick against which you can measure up upcoming product launches to products the company is already selling. You can figure out the pace at which one particular product is helping to boost a company’s bottom line. This, in turn, has effects on the company’s cashflow, growing operational costs, inventory, and so on.
All these refined analyses start from the same number or ratio: the projected growth rate for sales. Of course, this also goes on to be reflected in the growth of a company’s dividends, which we delve into later on.

What is a sustainable growth rate?

The sustainable growth rate of a company, often abbreviated as SGR, can be defined as follows:
The maximal threshold of growth that the company can achieve, before it is forced to boost its financial leverage.
In plain English, that’s as far as the company can grow on the revenue it generates internally, without having to borrow money from external sources. It’s useful to know how much a company can stretch its growth margins, because this helps management figure out:
  • A growth strategy for the long term;
  • How much capital it can acquire;
  • Projected cashflow;
  • A strategy for how much money the company can borrow.
graph displaying growth rate zones and sweet spot
Image source: Wikipedia
Here’s the formula for sustainable growth rate:
formula for calculating the sustainable growth rate
ROE stands for Return on Equity, while DPR is the Dividend Payout Ratio. Let’s have a look at an example:
Company B has a net income of $2 million. Its shareholder equity account holds $8 million. It has paid out dividends amounting to $750,000. The company’s ROE is 25%, i.e., $2 million/$8 million. Its DPR is 37.5%, i.e. $750,000/$2 million. So, in order to grow sustainably, the company needs to maintain a 15.625% rate of growth (i.e., 25% x (1-37.5%) = 15.625%.
In other words, if the company maintains this rate of growth, it can definitely do it without having to borrow money. There’s also another way for the company to grow, at an even faster rate of 25%: it could stop dividend payouts altogether.
And now, let’s see how dividend growth rate is calculated:

How to calculate growth rate for dividends

What is dividend growth rate?

Here’s a handy definition for you:
The Dividend Growth Rate is the annualized growth rate that a stock dividend experiences over a certain period of time, expressed in percentages.
What about that period of time, then? How’s that determined? It can be any particular span of time you want to look at, calculated by the method of least squares, as developed by mathematician Carl Gauss in 1793.
graph representation of the method of least squares
This method, typically used in estimates and regression analyses, is most often employed to determine the smallest sum of the squares of distances between a given number of points. In any case, if the least squares method proves too complex, one can always resort to a simple annualized figure for the span of time they are assessing.

Why is dividend growth rate important?

It’s now time to introduce another concept that’s essential to investors: the dividend discount model. This security pricing model takes the estimated future value of a stock’s dividends as a relevant index for the stock’s price. In doing so, it discounts extra internal growth that exceeds the estimated dividend growth rate.
The dividend discount model tries to look at the net present value of a stock and analyze it through the predicted value of dividends per share. If the present value of future dividends is more than the current market value of the stock, then the stock is overvalued; if it is less, then the stock is undervalued.
Though it’s not a rule set in stone, by and large, companies that have a solid track record of dividend growth are usually considered profitable and sound investments for the long term. At the same time, the dividend model does have some limitations:
  • It can’t be applied to companies that don’t pay dividends.
  • It can be difficult to predict the growth rate of dividends, since they are discretionary.
To better understand DDM, let’s analyze the following example:
The shares of Company C trade at $25 per share. Say you want to invest in them, but you also want to make sure they’re a good investment, with an ROI of at least 12%. You research the company and find out they pay $3 in annual dividends, with a predicted dividend growth rate of 4% per year.
Let’s plug all those numbers into the dividend discount model formula:
formula for calculting dividend discount model
For the particular company we’re analyzing, the numbers look as follows:
application of dividend discount rate formula
This indicates that the present value of the future dividends is bigger than the stock’s current market value, i.e., that the stock is undervalued.

Implied dividend growth rate

The ROE of a particular company can be calculated according to the following formula:
ROE return on equity formula
In the above equation, (g) stands for earnings growth rate, while (p) is the payout rate. By plugging a company’s rate of return on equity and estimated dividend payouts, you can calculate its earnings growth rate. Check out the following example:
Company D has a 10% return on equity and a dividend payout rate of 20%. This is enough information about the company to figure out its expected earnings growth rate. Let’s input the information into the formula above:
g = ROE*(1-p)
g = (10%)*(1-20%)
g = (.1)*(1-.2)
g = .08
g = 8%

Changing dividend policies

Changes in a company’s dividend policies are typically very good indicators as to its estimated earnings. That’s because companies only pay out dividends after their internal cash needs have been covered. If the dividend payout rate is cut, this may spell out reasons for worry for a company’s stakeholders.
The logic here is that the company is either:
  1. no longer making enough money to cover its internal cash needs;
  2. has increased its internal cash needs to the point where current earnings can no longer cover them.
Say a company lowers its dividend per share payout rate from $.50 to $.25. How do you think the stockholders will react? Presumably, they’ll start to wonder if the company is going through hard times. Has its growth rate slowed down? Are they no longer making as much money as they used to?
In such a scenario, it’s not uncommon for company stock prices to go down. Also, dividend policy changes have been known to impact a company’s clientele, i.e., the type of investors interested in owning stock in said company.
ordinary and consolidated dividends growth rate
Image source: Relia, Inc.
Capital gains and dividends are taxed differently, in that capital gains benefit from lower taxes. Depending on the tax bracket they’re in, a stockholder will decide in favor of either capital gains or dividends. The higher the tax bracket the stockholder is in, the less likely he/she is to prefer high dividend payouts.

Where to find a company’s dividend growth rate

As explained above, the evolution of dividends is not easy to predict, simply because such payouts are discretionary and some companies don’t readily disclose their values. However, companies that do have a strong track record of dividend growth will proudly present the information—most often, on their own websites.
To find information on a company’s dividend growth rate, head out to their website and check out their annual financial reports. In their most recent report, you’ll usually find information for at least the past 5 years. Do bear in mind that companies have different ways of presenting this information and the key difference between them lies specifically in the number of years included in this data set. The more data you get access to, the more likely it is that the company is proud of its own dividend payout evolution.
A very easy way to calculate dividend growth is by using Investopedia’s Compound Annual Growth Rate (CAGR) Calculator. The Compound Annual Growth Rate of an investment is a simple, albeit powerful tool for comparing the year-on-year return on investment of different types of investments. Here’s a concise definition of the CAGR:
The Compound Annual Growth Rate is a mathematical formula which calculates the mean annual growth rate of any given investment over a span of time that’s typically longer than a single year.
In order to calculate the CAGR of an investment, you need three distinct sets of data:
  • the value of the investment at the end of the period you’re analyzing it;
  • the initial value of the investment;
  • the number of years you’re looking at.
This is the CAGR formula:
formula for calculating compound annual growth (CAGR)
Do bear in mind that CAGR is not an actual number—it doesn’t stand for the real return rate you’re getting from your investments.
Think of it as an imaginary number, which helps describe your investments’ rate of growth, if only those investments were growing at a steady pace. Now, as most investors already know, things are rarely ever that smooth and simple in reality. More often than not, investment portfolios grow at an inconsistent rate. But if you do want a clearer picture of your portfolio’s ROI, CAGR is the indicator you want to look at.
Don’t worry if CAGR isn’t making that much sense for you just yet. It’s one of those concepts that make more sense when you see how they work in a concrete example. Here’s one:
Investor E wants to get the best ROI from his investment portfolio. It includes both stocks and property and investor E isn’t sure which one is bringing in the best ROI.
The current value of his investment is $1,500, while the initial value was $1,000, and he first started investing 3 years ago. Of course, his stock portfolio hasn’t been growing steadily: he’s seen 200% increases some quarters, but also 50% drops other quarters. Meanwhile, his property portfolio has increased its value from $100,000 to $130,000.
Investor E could try to figure out what type of investment yields the better ROI by looking at each annualized growth rate in turn. However, to get a clearer picture, he applies the CAGR formula and gets a smoothed annualized gain over his investment time horizon.
This is the CAGR of his stock portfolio:
[(1,500/1,000)^1/3]-1 = (1.5 ^ 0.3333) – 1
                                           = 0.1447
                                           = 14.5%
And this is how the CAGR formula applies to his property portfolio:
[(130,000/100,000)^1/3]-1 = (1.3 ^ 0.3333) – 1
                                                        = 0.0914
                                                        = 9.14%
To continue growing his portfolio with a satisfactory ROI, investor E decides to opt for stocks over property.
The CAGR is a simple and very flexible metric, which makes it suited for a wide range of uses. In the case of dividends, this metric takes into account the very nature of the market: volatility. Without it, it would be difficult to interpret the annualized growth of the investment. Growth is inconsistent, especially when dealing with a type of investment known for its discretionary nature.
Bear in mind that CAGR should not be used alone since, as is the case with all metrics, it does come with several limitations:
  1. Don’t fall into the trap of assuming that growth is ever smooth, simply because a particular stock shows a particular rate of growth. Always take into account the annual values that went into calculating CAGR.
  2. No matter how consistently a particular stock has grown over a particular span of time, don’t assume that the growth will unfailingly continue at that same pace. Several factors contribute to the rate of growth, including market volatility, and numerous other aspects.
  3. An impressive CAGR over 3 years might be concealing a much more meager rate for, say, the past 5 years. Always ask to see as much historical information as is available and also do your own sleuthing to see if the data is consistent with other company metrics.
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