Calculate Intrinsic Growth Rate
The intrinsic growth rate (IGR) is the maximum rate at which a company can grow its earnings and dividends without external financing (debt or equity). It represents a company's ability to self-fund its growth.
Results
Understanding Intrinsic Growth Rate
The Intrinsic Growth Rate (IGR) is a fundamental concept in financial analysis, particularly for investors seeking to understand a company's sustainable growth potential. It's the maximum growth rate a company can achieve by reinvesting its own earnings without altering its financial leverage or issuing new equity.
The Formula for Intrinsic Growth Rate
The most common formula for IGR is derived from the DuPont analysis and is calculated as follows:
IGR = Net Profit Margin × Retention Ratio × Return on Equity
Where:
- Net Profit Margin: This measures how much profit a company makes for every dollar of sales. It's calculated as (Net Income / Revenue).
- Retention Ratio: This is the percentage of net income that a company reinvests back into the business. It's calculated as (1 – Dividend Payout Ratio) or (Retained Earnings / Net Income).
- Return on Equity (ROE): This measures how effectively a company uses shareholder investments to generate profits. It's calculated as (Net Income / Shareholder's Equity).
Often, ROE is not directly provided, but can be calculated using its components from the DuPont framework:
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
Substituting ROE into the IGR formula, we get:
IGR = Net Profit Margin × Retention Ratio × (Net Profit Margin × Asset Turnover × Equity Multiplier)
However, a more direct and commonly used IGR formula when ROE is not explicitly given but its components are, is:
IGR = (Net Income / Shareholder's Equity) × (1 – Dividend Payout Ratio)
If we are given the components of ROE (Net Profit Margin, Asset Turnover, Equity Multiplier) and the Retention Ratio, the calculation becomes:
IGR = (Net Profit Margin × Asset Turnover × Equity Multiplier) × Retention Ratio
Why is Intrinsic Growth Rate Important?
The IGR provides a theoretical upper limit on growth. If a company is growing faster than its IGR, it implies it's relying on external financing, which can increase financial risk. Conversely, a company growing slower than its IGR might not be fully utilizing its potential to reinvest earnings.
Example Calculation
Let's consider a company with the following financial metrics:
- Net Profit Margin: 10% (0.10)
- Retention Ratio: 60% (0.60)
- Asset Turnover Ratio: 1.5
- Equity Multiplier: 2.0
First, we calculate the Return on Equity (ROE):
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
ROE = 0.10 × 1.5 × 2.0 = 0.30 or 30%
Now, we can calculate the Intrinsic Growth Rate:
IGR = ROE × Retention Ratio
IGR = 0.30 × 0.60 = 0.18 or 18%
This means the company can sustain an 18% growth rate in its earnings and dividends without needing to take on more debt or issue new stock, assuming these ratios remain constant.