Topic 56
How Fast Can the Target Grow?
Topic 56 explores the limitations and drivers of internally generated sustainable growth and presents a method for determining sustainable growth. Testing the growth assumption of target business plans can be very useful during due diligence and negotiations.
- Barring the introduction of new equity, internally generated sustainable growth (gs) in the business (sales, earnings before interest, tax and depreciation and amortization (Ebitda), net operating profit after tax (NOPAT), and free cash flow (FCF)) eventually is limited to approximately a rate equal to the sustainable return on net operating assets, r (equal to NOPAT/Net operating capital) adjusted for dividend payout (d) and leverage (Debt to market value of Capital ratio, D/C) as shown:
- The higher the r, the greater the sustainable growth rate.
- The higher the d, the lower the sustainable growth rate.
- The higher the sustainable D/C, the higher the sustainable growth rate as more capital is available to the firm up to the point that D/C is reached.
- The practical implication of this expression is that if actual growth (gT) exceeds the sustainable rate (gs), at some point, without an increase in r, the new debt required to fund the growth will climb to a point where D/C is reached. At that point, lenders will curtail the availability of lending or invoke dividend restrictions and other ...
