We got some flack for our stock market valuation. The key issue readers took issue with was (not surprisingly) the growth rate. As we said before, all the inputs required to value an index like the S&P 500 are impossible to estimate with accuracy. This is why the valuation game has little impact on stock prices in the near term. However, the use of a “Sustainable Growth Rate” (SGR) as some of you proposed is meaningless in today’s technology driven economy. Recall the definition of SGR,
Sustainable growth rate = (1 – Payout ratio) (Return on equity)
Today’s S&P 500 has had a negative SGR for several years now. What this means is that, in aggregate, firms are paying out more to shareholders than they made in earnings. The chart below illustrates this for free cash flow, but the same has true for net income as well. Barkley’s produced the chart with the ominous warning that the “Party is Almost Over“. That was over a year ago and yet earnings continue to grow.
Now it is true that payout ratios above 100% are unsustainable. Firms today, in aggregate, have an unprecidented amount of cash on their balance sheet and can borrow at exceptionally low interest rates. Many of these firms have decided that it makes more sense to pay this cash back to shareholders or take advantage of cheap borrowing rates to leverage up their capital structures. We are not going to speculate on whether these decisions are optimal. What we can say, however, is that there is no reason to believe that growth prospects for S&P 500 firms equals zero. This is true even if firms, in aggregate, payout 100% of their earnings in all future periods.
The SGR is widely acknowledged as inappropriate for smaller growth firms. This is easily evidenced by the fact that a SGR cannot even be calculated for growth firms without profits.
To illustrate, suppose you take $100k of your own money and start a software business. You hire a bunch of tech savvy programmers and buy some computers. For three years you expense your costs as shown below and fail to make a profit. Finally, in year four your website starts getting traffic and your revenue explodes. Profits surge because your costs have largely expensed. You decide to payout all the profits to yourself because you have $50k on your balance sheet determine that to be sufficient to cover any liquidity needs.
So how does your firm grow? This is where the assumptions of SGR break down. SGR assumes that growth comes from current period investment. For example, suppose a firm earns 15% return on equity and reinvests 80% of earnings. SGR assumes that the reinvested 80% also returns 15%. This would then lead earnings to grow by 12% = 15% x 80%.
This makes sense in industries that involve the production of physical things. For example, if you were producing cars instead of software, much of your growth would require additional investment in tangible assets like factories. Moreover, expenses in prior years would be toward things like raw materials that would in no way help to improve growth in future years.
But the SGR concept does not make a lot of sense in today’s economy which is dominated by software, platforms, network effects, and technology firms more generally. Take Amazon as an example. Here we have a company that had essentially zero cumulative net income from 2012 – 2014. This effectivly makes the SGR meaningless because they had nothing to pay out. Still, Amazon profit growth has soared since 2014.
Amazon is just one company, but a closer look at its financials reveals a larger point.
Amazon was paying for its future growth through its investment in “marketing” and “technology” (see excerpts below). These expenses are largely expensed, but are the grown drivers that made Amazon into the retail bohemith that it is today!
“Marketing – We direct customers to our websites primarily through a number of targeted online marketing channels, such as our Associates program, sponsored search, social and online advertising, television advertising, and other initiatives. Our marketing expenses are largely variable, based on growth in sales and changes in rates.”
“Technology costs consist principally of research and development activities including payroll and related expenses for employees involved in application, production, maintenance, operation, and development of new and existing products and services, as well as AWS and other technology infrastructure costs.”
For Amazon to continue to grow it only needs to continue hiring and developing great people that keep their platform competitive. Reinvestment of profits have become part of this equation since 2014, but reinvestment of profits is not a requirement. In fact, Jeff Bezos would be wise to continue expensing investments in technology and marketing up front rather than plow profits back into the company after tax.
One reason companies have been paying out so much of their income in dividends and buybacks is because they have gotten better at expensing investments. By expensing investments up front a company is able to label the investment as a cost and thereby avoid paying taxes. This is profitable in the long run because it allows those tax savings to compound. The same logic applies to individual investors that hold on to winning stocks instead of selling them and buying them back. Realizing a capital gain and paying taxes decreases the amount of the stock you can buy back.
The implication here is that companies and indexes can grow even when they pay out all of their earnings. Growth comes from many sources including historical research & development, network effects, economic growth, free marketing (word of mouth), and investments that firms are clever enough to label as costs to postpone paying taxes.
That said, a negative SGR is an indication that firms are having trouble finding profitable investment opportunities. While some firms may be paying out dividends and buybacks for inappropriate reasons like boosting share prices and signaling before issuing debt, firms are supposed to pay out income they can’t reliably reinvest and earn more than their cost of capital.
The key point here is that “sustainable growth” for many firms can be achieved without reinvesting profits. This is obviously true for growth companies that don’t have profits. It is also empirically true for the S&P 500 which has experienced much higher growth in earnings over the past decade than the SGR would suggest.
Stocks may come crashing down tomorrow…but it wont be because of the “Sustainable Growth Rate”.
Feel free to share your own thoughts on the sustainable growth rate. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.