Tuesday, May 3, 2011
Saturday Meeting: SGR and the PRAT model
Last Saturday, we officially start the systematic discussion of fundamental analysis. In addition to a review of the balance sheet, I brought something interesting to the table: Sustainable Growth Rate (SGR) along with the PRAT model!
The SGR is a very important concept in fundament analysis and equity evaluation, because it measures how quickly earnings can continue to grow indefinitely if the company holds an unchanged debt-to-equity ratio and doesn’t issue any new equity; in other words, the rate at which a firm can grow with only internal generated funds. It is a little tricky because people (even including some teammates :-P) may easily think the SGR is the same thing with the growth rate g we use in the FCF equity evaluation, however, the answer is yes and no.
SGR is the rate we can calculate based on the historical data from financial statements with the PRAT model, where SGR is the product of the profit margin (P), the retention rate (R), the asset turnover (A), and the financial leverage (T). Among them, R and T are the firm’s financing decision, while the product of P and A is the ROA, which presents firm’s performance. We then can use those four factors as building blocks in developing an estimate of a firm’s growth rate g. If we forecast the actual growth rate greater than SGR, the firm need increase either its retention ratio, profit margin, total asset turnover, or leverage; otherwise, the firm will have to issue equity. In sum, when you are looking for an appropriate growth rate for the terminal value, you’d better have a look at the calculated SGR as a benchmark for the overall analysis.
The part I enjoy most in our meetings is that all of we are always expecting to learn new knowledge from each other, through challenging each other, intensive group discussion, or even debates. We trust our teammates, and push each other move forward as well.
By the way, it was a pretty beautiful day last Saturday.
Folks, summer is coming…
But before enjoying the summer time, good luck with all of your finals!