| The sustainable
growth model looks at how much growth a firm can generate by maintaining the same
financial relationships as the year before. ROE = Net
income or after-tax earnings / book value
Or
ROE = Earnings per share (EPS) / Book value per share (BVPS)
ROE = $1.20 (1994, full year) / $6.44 (1993, year end)
Rearrange the formula to show the value of earnings per share
for 1994
EPS = ROE X BVPS
$1.20 = 18.63% X $6.44
Future growth in earning comes from the firm reinvesting in
new plant and equipment and thus being able to generate more income for next year.
In this case, the firm paid out a dividend of $0.38 in 1994
and retained $0.82 ($1.20 - $0.38).
The $0.82 gets added to the beginning book value per share to
get ending book value of $7.26 ($6.44 + $0.82) for 1994.
If the firm can continue to earn 18.63 percent on its equity,
it will earn $1.35 per share for 1995. This can be computed as follows:
EPS 1995 = ROE X BVPS year end 1994
EPS 1995 = 18.63% X $7.26
EPS 1995 = $1.353
One of the conditions of growth is that the firm's must
retain some earnings. If the firm paid out all its earnings in dividend, it would start
1995 with the same book value and would experience no growth. The more earning retained
the higher the growth rate would be. In this case, it retained $0.82 out of $1.20 in
earnings. This is called the retention ratio.
Retention ratio (B) = EPS -Dividends per share / EPS
Retention ratio (B) = $1.20 - $.38 / $1.20
Retention ratio (B) = 0.6833 or 68.33%
Therefore the growth rate for 1995 is
Growth rate 1995 = ROE 1995 X Retention Ratio (B)
Growth rate 1995 = 18.63% X 68.33%
Growth rate 1995 = 12.7% |