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Investors ideally ought to pick stocks that will rise faster than others and the market as a whole.
Incredibly, some investors buy shares of companies with no growth at all. And others find it hard to determine growth prospects in the first place. What's more, expectations of future growth make the task even more difficult.
To do so, many investors focus on earnings growth or return on equity. While important, those factors are backward looking. A method known as sustainable growth can help provide insight into future growth.
Only companies in the same industry are comparable. Pharmaceutical firms, for instance, tend to have substantially higher growth rates than those in industries that don't generate as much cash to fund their operations.
The theory behind the calculation of sustainable growth is that a company's growth is fueled by net income that flows from the income statement to the balance sheet as retained earnings. Dividends are an impediment, as they don't land on the balance sheet.
As a result, sustainable growth is a calculation of return on equity multiplied by the so-called plowback ratio. That is, earnings per share minus the dividend paid over the earnings per share. That calculation determines the percentage of the earnings that a company is reinvesting in itself rather than paying out to shareholders.
The formula for sustainable growth and the plowback ratio can be written as follows:
Sustainable growth = ROE x plowback ratio.
Plowback ratio = (earnings per share - dividend per share)/earnings per share.
The calculation can help identify companies in an industry that have the best growth prospects, given their ROE and plowback. The table below shows this calculation applied to drugmakers. While some companies, such as
, may be so far behind their competitors that this adjustment won't affect their rankings, the resulting rankings should help clarify the prospects for tightly grouped competitors.
Johnson & Johnson
remained closely grouped. But Johnson & Johnson picked up a considerable amount of ground on the frontrunners in the industry.
all were within 10 percentage points of one another, according to ROE. After applying the sustainable growth calculation, the order is reshuffled, resulting in Bristol-Myers taking the top spot.
That suggests, based on the amount of cash Bristol-Myers is reinvesting in its business, that it should have the biggest growth potential of the pharmaceutical companies analyzed.
This prediction seems plausible. Over the past year, as most drugmakers fell by double digits, Bristol-Myers lost only 2.2% of its value.
It's important to remember that the calculations are based on the assumption that these companies will maintain the same capital structure (the amount of debt employed in the business). Should any of the companies choose to drastically change their debt load, growth could be accelerated at the expense of risk.
Using the sustainable growth calculation along with other factors, such as P/E ratios, and competitive factors can greatly improve stock picking.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.