Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Slides prepared by Hersh Shefrin Managing Growth Chapter Four

4-2 Introduction It is possible for companies to grow too quickly. It is possible for companies to grow too slowly. Growth needs to be managed.

4-3 Sustainable Growth A company’s sustainable growth rate is the maximum rate it can grow without depleting financial resources. We will discuss: How to compute a company’s sustainable growth rate? How to respond when growth veers off the sustainable trajectory?

4-4 Phases (LifeCycle of Business) 1. Startup (usually with losses) 2. Rapid growth (with infusions of outside financing) 3. Maturity (generating cash) 4. Decline (marginally profitable, with cash to search for new products, investments)

4-5 The Sustainable Growth Equation Consider a situation when a company has a target dividend payout policy, target capital structure, and does not wish to issue new shares or repurchase existing shares. Consider a firm whose sales are growing rapidly. Sales growth requires investment in AR, inventory, and productive capacity.

4-6 FIGURE 4.1 New Sales Require New Assets, Which Must Be Financed

4-7 g* What limits the rate at which this company can increase sales or, more generally, its overall expansion? From the previous figure, the limit to growth is the rate at which equity expands.

4-8 Plowback (Retention Ratio) If the firm pays out all of its earnings as dividends, it cannot grow equity internally. If R stands for the plowback ratio, then g* is the product of R and earnings over equity. g* = R x ROE. g* = R x P x A x T or PRAT, where T is assets/equity based on beginning of period equity, A is asset turnover, and P is profit margin.

4-9 Levers of Growth The levers of growth here are PRAT. g* is the only sustainable growth rate consistent with these ratios. A company that grows too quickly might not be able to increase operating efficiency, and therefore resort to increased leverage. Sometimes that is like playing Russian roulette.

4-10 Balanced Growth ROA is Net income / Assets. With this definition, g* is the product of (RT) and ROA, where RT reflects financial policy and ROA reflects operating performance. Sometimes referred to as internal growth. Look at Figure 4.2 on the next slide, where sales growth off the line with slope RT generate either cash deficits or surpluses.

4-11 FIGURE 4.2 A Graphical Representation of Sustainable Growth

4-12 Unbalanced Growth What does this mean? A company with unbalanced growth has 3 choices: 1. Change its growth rate. 2. Change its ROA. 3. Change its financial policy, meaning the slope of the line.

4-13 TABLE 4.1 A Sustainable Growth Analysis of Medifast, Inc., 2006—2010

4-14 Still in Deficit Mode? Look at Figure 4.3. In 2010, was Medifast still in cash deficit mode?

4-15 FIGURE 4.3 Medifast’s Sustainable Growth Challenges, 2006—2010

4-16 What does this mean? The general purpose of this analysis is for management to understand the connection between proposed changes in sales and the financing of the assets to sustain those sales. The planning for future needs and changes in actions can lead the company through a range of needs for cash.

4-17 What To Do When Actual Growth Exceeds Sustainable Growth? If growth is temporarily too fast, just borrow and wait for it to slow down. If not, then there is a laundry list of actions to take: Sell new equity Increase financial leverage Reduce dividend payout Prune marginal activities Increase prices Merge with a “cash cow”

4-18 Sell New Equity Get cash Increase borrowing capacity Difficult to do in most countries

4-19 Increase Leverage Raises cash Also raises risk of bankruptcy

4-20 Reduce the Payout Ratio Saves cash that can be used to build up equity Can anger shareholders who respond by selling their stock, thereby driving down stock price.

4-21 Profitable Pruning Raises ROE, and therefore earnings, and therefore retained earnings. Retained earnings are part of equity. Prune by un-diversifying unrelated product lines with no synergy. Who benefits from corporate diversification, shareholders or managers? Un-diversifying generates cash from the sale of assets.

4-22 Pricing Increases ROE, if %-demand doesn’t fall by more than the %-price increase.

4-23 Merger Find a cash cow (white knight, if threatened) with deep pockets.

4-24 What To Do When Sustainable Growth Exceeds Actual Growth? Ask if the situation is temporary. If yes, build up cash. If no, ask if the phenomenon is industry- wide, or within the firm. If within the firm, look for new product lines, improvements, etc.

4-25 Ignore the Problem? Accumulate cash and slow growth attracts corporate raiders Why? What do raiders believe?

4-26 Return The Money To The Shareholders Increase dividends Repurchase shares Temptation is to invest in assets that reduce corporate value but increase management’s empire

4-27 Buy Growth Buy other businesses, especially ones that need cash because they are growing rapidly. History suggests that returning the money is the better option.

4-28 Sustainable Growth and Inflation Inflation increases the nominal value of assets such as AR, inventory, and fixed assets (with a lag). These still need to be financed, and the problem is acute if prices are difficult to raise quickly. The issue is important if banks miss the connection.

4-29 New Equity Financing FIGURE 4.5 Net New Equity Issues 1975—2010

4-30 Acquisitions Companies reduce their shares by repurchasing them or by acquiring the stock of another firm for cash or debt. The numbers suggest that companies sell new shares about once every 20 years.

4-31 IPOs Check the graph of IPOs relative to gross public equity issues Modest 25% of new equity raised over the period In 2000, IPOs contributed 5% of total external capital IPOs trended downward, a concern to many

4-32 Why Don’t US Companies Issue More Equity? Other sources generated sufficient cash Equity is expensive to issue (flotation) Fear of diluting EPS in the short-run Concern that their stock is undervalued in the market Windows close