Today, I'll be talking about an important concept of "Self Sustaining Growth Rate".

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Let's begin

You must know that there are only two value drivers of a company:

1. Growth
2. Return on Capital Employed

Everything else, be it, margins, moat, industry structure, are some way or other related to these two.

Growth is simple to understand. It is the rate at which the company grows its free cash flow.

Here's a thread on free cash flow which I had written: https://twitter.com/theprofitabull/status/1327480298636918784?s=20

You would want to invest in a company that is growing its Free Cash Flow along with its sales, and not just sales alone.

Growth is easier to achieve for a company.

Let's say that company X grew its profits from ₹1000 crore to ₹1200 crore.

It will be praised all around the street for achieving 20% growth.

But what if the company infused an additional ₹2000 crore of capital to achieve that growth.

That brings us to the second part of value drivers, that is, Return on Capital Employed.

@money_theory had written a great thread on ROCE long back. https://twitter.com/money_theory/status/1309097930415054850?s=20

Return on Capital Employed will tell you about the quality of a business.

Higher the ROCE, higher is the quality of the underlying business.

In our example, company X will be having a ROCE of 10% (200/2000).

Which is not a good number if we look at it.

But rarely do people focus on ROCE and more they do on profit growth.

Now that you know about the two values drivers, let understand what is Self Sustaining Growth Rate.

First, let us understand the meaning of self-sustaining.

This is what you'll get when you search for it:

"able to continue in a healthy state without outside assistance"

This is what we want in the companies where we invest - the ability to grow "without outside assistance"

This means that Self Sustaining Growth Rate is the maximum rate at which a company can grow without taking on any external debt or raising equity.

Let's say that a company has a total capital employed of ₹5000 crores.

On that capital, the company generated a free cash flow of ₹1000 crores, meaning that it has a ROCE of 20%.

This means the company has ₹1000 crores more cash than it had the year earlier.

This cash can be used in one of the following ways —

1. Payout to shareholders in the form of dividends or buyback
2. Invest in the growth of the company

If the company decides to pay dividends, then that capital can't be used for further growth.

On the other hand, if a company decides to invest all of it in growth, it will have a capital employed of ₹6000 crores (5000+1000).

This means if the company can maintain its ROCE of 20%, it will be able to generate a free cash flow of 1200 crore (6000 x 20%), leading to a growth rate of 20%.

But, this is the ideal scenario. Let's take a realistic scenario where the company pays out ₹250 crores in the form of dividends to its shareholders.

The payout ratio comes out to be 25%. Remember, calculate the dividend payout ratio on free cash flow, and not on net profits.

This means the company has a balance of ₹750 crore which it can deploy for further growth.

This means the capital employed will now be ₹5750 crores.

Provided the company maintains the ROCE of 20%, the free cash flow generated for the next year comes out to be ₹1150 crore.

This is a 15% growth in free cash flow. Even if the company plans to cut the dividend, it might only be able to grow at 20%.

This is the maximum rate at which the company can grow.

Whatever happens, a company cannot grow beyond its ROCE consistently.

If it does, sooner or later it will have to raise external capital either through debt or equity.

Both the routes will lead to a decrease in EPS, and will in turn hurt the existing shareholders.

If you want to calculate the Self Sustaining Growth Rate (SSGR) of a company, you can do so by using this —

SSGR = ROCE x (1 - Payout)

Remember, both payout and ROCE are calculated in terms of Free Cash Flow.

By calculating Self Sustaining Growth Rate and comparing it with the actual growth rate over a period of time, you will know the true picture of that company's health.

If you find this valuable, kindly retweet the below tweet https://twitter.com/theprofitabull/status/1384725201959624706?s=20

@dmuthuk
@Vivek_Investor