Costco - Sustainable Growth Model, 1997-2001

Topics: Generally Accepted Accounting Principles, Financial ratios, Revenue Pages: 10 (2978 words) Published: December 2, 2007
Sustainable Growth Model
[NOTE: For all steps, refer to the accompanying Sustainable Growth Tables" of ratio calculations for Costco and its competitors for all years measured. The table are located at the close of this section.]

The sustainable growth rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged. The model allows an analyst to isolate drivers that have led to changes in historical growth in order to isolate causes of change. It is represented in four steps.

Step 1: Profitability and Earnings Retention
At the end of each year the return that Costco realizes on equity capital can either be reinvested back into the business or paid out to investors as dividends and common stock repurchases. If no dividends or share repurchases were made and earnings were reinvested back into the business at the same incremental rate of return, the company's return on equity would hold constant over time. In reality, most companies, including Costco, frequently experience changes in their return on equity, and distribute some portion of earnings to investors. Therefore, at the highest level, sustainable growth rate for Costco and its competitors can be expressed as the product of the following two ratios:

∑ Earnings Retention Ratio = 1 – Dividend Payout Ratio ∑ Return on Equity (ROE) = Net Income / Owner's Equity

As demonstrated in the accompanying tables, both Costco and Wal-Mart Corp retained all of their earnings for the periods 1997 through 2001 so their dividend payout ratio is 0 and its earning retention ratio is 1. This means that both Costco and Wal-Mart Corp. retain 100% of earnings therefore paying out 0% in dividends, which is indicative of rapidly expanding companies.

If Costco paid out some of its earnings in dividends, like Sears or BJ's Wholesale, its earnings available for reinvestment in the business would have decreased. This is the case for both BJ's Wholesale and Sears though the trend for each company is different. BJ's Wholesale dividend payout ratio has consistently increased since first beginning any payout is 1999. Therefore, their earning retention ratio has decrease has consistently decreased since 1999 and, in 2001 it was negative for the first time.

Sears has sustained negative earnings retention for all the years measured. From 1997 through 1999 the ratio was close to zero. In 2000 Sears' net income dipped substantially causing the dividend payout ratio to climb and the earnings retention to plummet however, the amount of dividends paid was consistent with previous year. This indicates that Sears may have been covering for a poor performance by not decreasing the amount of dividend paid so to maintain stock price.

Return on equity is an overall measure of performance of a company because it measures how much profit is generated in net income for every dollar invested in equity capital. Good companies typically have equity values from .15 or .25 (or 15% to 25%). Costco's ROE has fluctuated up and down over the past five years only surpassing .15 in 1998 at .155. The lowest was 1999 at .112. Costco's ROE has maintained near .12 over the five years measured which indicates consistent company performance.

Although Costco's ROE has been slightly lower than the minimum value of a "good" company, it has not fluctuated as much as it's major competitors. After multiple years of ROE near .20, Sears dropped to .12 meaning that shareholders will earn over $0.09 less per dollar they invest than last year and an $0.08 decrease overall since 1997. Similarly, BJ's Wholesale had an $0.08 decrease in ROE in the last year and an overall $0.04 decrease for the past five years. Both Sears and BJ's ROE indicate potential for poor company performance.

Wal-Mart Corp has shown a historical increase in ROE. Though is has fluctuated from year to year, the past two years have been consistently high. Also, the...
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