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Sustainable growth rateFrom Wikipedia, the free encyclopedia

According to PIMS (Profit Impact of Marketing Strategy) an important lever of business success is growth. Among37 variables, growth is mentioned as one of the most important variables for success: market share, market growth,

marketing expense to sales ratio [1] or a strong market position.[2]

The question how much growth is sustainable is answered by two concepts with different perspectives:

The Sustainable Growth Rate (SGR) concept by Robert C. Higgins, describes optimal growth from a

financial perspective assuming a given strategy with clear defined financial frame conditions/ limitations.

Sustainable growth is defined as the annual percentage of increase in sales that is consistent with a defined

financial policy (target debt to equity ratio, target dividend payout ratio, target profit margin, target ratio of

total assets to net sales). This concept provides a comprehensive financial framework and formula for case/

company specific SGR calculations.[3]

The Optimal Growth concept by Martin Handschuh, Hannes Lösch, Björn Heyden et al. assesses

sustainable growth from a total shareholder return creation and profitability perspective - independent of a

given strategy, business model and/ or financial frame condition. This concept is based on statistical long-term assessments and is enriched by case examples. It provides an orientation frame for case/ company

specific mid- to long-term growth target setting.[4]

Contents

1 Sustainable growth rates (SGR) from a financial perspective

2 Optimal growth rates from a total shareholder value creation and profitability perspective

2.1 Relationship between revenue growth, total shareholder value creation and profitability

2.2 Base strategies and growth moves2.3 How to achieve long-term growth in the sweet-spot and beyond

2.3.1 Preconditions

2.3.2 Levers and strategy3 Criticism

4 References

5 Further reading

Sustainable growth rates (SGR) from a financial perspective

The sustainable growth rate according to Robert C. Higgins is the maximum growth rate a company can achieveconsistent with the firm`s established financial policy. Basically, it is calculated as:

SGR = (pm*(1-d)*(1+L)) / (T-(pm*(1-d)*(1+L)))

pm is the existing and target profit margin

d is the target dividend payout ratio

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L is the target total debt to equity ratio

T is the ratio of total assets to sales

In order to grow faster, the company would have to invest more equity capital, increase its financial leverage orincrease the target profit margin.

The sustainable growth rate model assumes several simplifications such as depreciation is sufficient to maintain thevalue of existing assets, the profit margin remains stable (also for new businesses), the proportion of assets andsales remains stable (also for new businesses) and the company maintains its current capital structure and dividendpayout policy. The sustainable growth rate model has implications for valuation models, as for instance the Gordonmodel and other discounted cash flow models require a growth estimate that can be sustained for many years. Thesustainable growth rate can be a check if business plans are reasonable.

Optimal growth rates from a total shareholder value creation andprofitability perspective

Optimal Growth according to Martin Handschuh, Hannes Lösch and Björn Heyden is the growth rate whichassures sustainable company development – considering the long-term relationship between revenue growth, totalshareholder value creation and profitability. Assessment basis: The work is based on assessments on theperformance of more than 3500 stock-listed companies with an initial revenue of greater 250 million Euro globallyand across industries over a period of 12 years from 1997 till 2009. Due to this long time period, the authors

consider their findings as to a large extent independent of specific economic cycles.[4]

Relationship between revenue growth, total shareholder value creation andprofitability

In the long-term and across industries, total shareholder value creation (stock price development plus dividendpayments) rises steadily with increasing revenue growth rates. The more long-term revenue growth companiesrealize, the more investors appreciate this and the more they get rewarded.

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Return on Assets (ROA), Return on Sales (ROS) and Return on Equity (ROE) do rise with increasing revenuegrowth up to 10 to 25% and then fall with further increasing revenue growth rates.

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Also the combined ROX-index (average of ROA, ROS and ROE) shows rises with increasing growth rates to abroad maximum in the range of 10 to 25% revenue growth per year and falls towards higher growth rates.

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The authors attribute the continuous profitability increase towards the maximum of two effects:

1. Profitability drives growth: Companies with substantial profitability have the opportunity to invest more inadditional growth.

2. Growth drives profitability: Substantial growth may be a driver for additional profitability, e.g. by higher

attractiveness for high performing young professionals, higher employee motivation, higher attractiveness forbusiness partners as well as higher self-confidence.

Beyond the profitability maximum extra efforts to handle additional growth – e.g. based on integrating new staff inlarge dimensions and handling culture and quality - do rise sharply and reduce overall profitability.

The combination of the patterns of revenue growth, total shareholder value creation and profitability indicates threegrowth zones:

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Low Return: Low profitability and low value generation below 10% per year

Long-term Sweet-Spot: Solid value generation and highest on average profitability in the revenue growth

interval from 10% to 25% per year

High Speed: Even higher total shareholder value generation however in combination with lower profitabilitybeyond 25% per year

Growth rates of the assessed companies are widely independent of initial company size/ market share which is inalignment with Gibrath`s law. Gibrat's law, sometimes called Gibrat's rule of proportionate growth is a rule definedby Robert Gibrat (1904–1980) stating that the size of a firm and its growth rate are independent. Independent ofindustry consolidation and industry growth rate, companies in many industries with growth rates in the range of 10to 25% revenue growth p.a. have both, higher total shareholder value generation as well as profitability than theirslower growing peers.

Base strategies and growth moves

These findings do suggest two base strategies for companies:

For companies (e.g. in established markets like central Europe and USA) with low single digit growth rates:

Consider acceleration of growth given the fact that TSR and profitability are higher in the sweet-spot

For companies (e.g. in fast growing regional markets like China with India and/ or rapidly growing industry

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segments) with growth rates beyond 25%: Consider best ways to “digest”/ and to stabilize rapid growth and

ensure a “soft landing” should market growth come to a sudden stop.

How to achieve long-term growth in the sweet-spot and beyond

The authors have identified a set of preconditions and levers to achieve long-term growth in their defined sweet-spot and beyond:

Preconditions

Generating a common understanding regarding growth and profit ambitions among the management team as

a prerequisite for aligned and coordinated strategy development and implementation

Understanding relevant markets (current or future promising markets). Generating market foresight when

identifying and assessing growth initiatives, e.g. megatrends and scenario analyses, segment specific

benchmarking and in depth assessments, market demand projections

Levers and strategy

Applying formulas for rapid growth, e.g. maxing out the number of relevant customers, maxing out the share

of wallet and lifecycle potentials, continuous innovation, killer offerings, network based growth, M&A/buy-

and-build driven growth, franchising proven business concepts, pyramid-like network expansion and

managing value networks

Defining the growth strategy as a portfolio of best suited growth initiatives considering a multidimensional setof criteria, e.g. ease of implementation, growth and profit impact, expected risk vs. return, cash flow stability

Making growth happen: Strategy and corresponding culture must be addressed in a consistent way, e.g.

creating the case for growth, clearly defining and communicating vision and strategy as well as actively

developing and energizing the organization.[4]

Criticism

As described the sustainable growth rate (SGR) concept by Robert C. Higgins is based on several assumptionssuch as constant profit margin, constant debt to equity ratio or constant asset to sales ratio. Therefore, generalapplicability of SGR concept in cases where these parameters are not stable is limited.

The Optimal Growth concept by Martin Handschuh, Hannes Lösch, Björn Heyden et al. has no restrictions tocertain strategies or business model and is therefore more flexible in its applicability. However, as a broadframework, it only provides an orientation for case/company specific mid- to long-term growth target setting.Additional company and market specific considerations, e.g. market growth, growth culture, appetite for change,are required to come up with the optimal growth rate of a specific company.

Additionally, considering the increasing criticism of excessive growth and shareholder value orientation byphilosophers, economists and also managers, e.g. Stéphane Hessel, Kenneth Boulding, Jack Welch (nowadays),one might expect that investors` investment criteria might also change in the future. This may lead to changes in therelationship of revenue growth rates and total shareholder value creation. Regular reviews of the optimal growthassessments may be used as an indicator for the development of stock markets` appetite for rapid growth.

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References

1. ^ Lancaster, Geoff; Massingham, Lester; Ashford, Ruth (2001): Essentials of Marketing: Text and Cases,Mcgraw-Hill Higher Education, p. 535

2. ^ Dibb, Sally; Simkin, Lyndon; Pride, William (2005): Marketing.Concepts and Strategies, 5th edition, HoughtonMifflin, p. 676

3. ^ Higgins, Robert (1977): How much growth can a firm afford, Financial Management 6 (3) p. 7-16

4. ̂a b c Börnsen, Arne; Körner, Florian (2011): Optimal Growth, Conceptualization of a strategy to benefit fromOptimal Growth, Mannheim Business School

Further reading

Fonseka, Mohan; Tian, Gaoloang (2011): The most appropriate Sustainable Growth Rate (SGR) Model for

Managers and Researchers, American Accounting Association

Graeme, Deans; Kroeger, Fritz (2004): Stretch!: How Great Companies Grow in Good Times and Bad,

John Wiley & Sons

Handschuh, Martin (2011): What we can learn from self-made billionaires?, WHU Otto Beisheim School of

Management lecture

Handschuh, Martin; Loesch, Hannes (2011): Optimal Growth – Does it exist and if so how to realize it?,Mannheim Business School lecture

Handschuh, Martin; Reinartz, Sebastian; Heyden, Björn (2011): Megafusionen als Lehrbuch, M&A Review

05/2011

Higgins, Robert (1981): Sustainable growth under inflation, Financial Management 10 (4) p. 36-40

Jonk, Gillis (2006): Resources for Growth, published in: executive agenda, ideas and insights for business

leaders, volume IX, Number 1, 2006, A.T. Kearney

Neumann, Dietrich; Sonnenschein, Martin; Schumacher, Nikolas (2003): Fünf Wege zu organischemWachstum: Wie Unternehmen antizyklischen Erfolg programmieren können, campus Verlag

Slywotzky, Adrian; Wise, Richard; Weber, Karl (2004): How to Grow When Markets Don’t:

Discovering the New Drivers for Growth

Sonnenschein, Martin (2011): Innovation and Growth in Volatile Times, Stuttgarter Strategieforum

Velthius, Carol (2010): Surfing the Long Summer: How Market Leaders Grow Faster Than Their

Markets, Infinite Ideas

Zook, Chris (2007): Unstoppable: Finding Hidden Assets to Renew the Core and Fuel Profitable

Growth; Mcgraw-Hill ProfessionalZook, Chris; Allen, James (2010): Profit from the Core: A Return to Growth in Turbulent Times;

Harvard Business Press

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