Course 409: The Dividend Drill  
Assess the Company's Core Growth Potential  

One key to this analysis is understanding how much investment is required to fund this growth. Few areas of the market are bursting at the seams, but most companies and industries have at least some growth potential over time as the U.S. economy expands (figure 3%4% per year plus inflation) and emerging markets open up. Inflation can be a tailwind, toothough taking price increases for granted with manufacturingoriented firms is not necessarily a good idea. Fortunately for most mature businesses, supporting this baseline level of growth is relatively inexpensive, and therefore high return. Another and often simpler way to think about the cost of growth is to look at the company's free cash flow as a percent of net income. Since free cash flow includes the cost of capital investments that support growth initiatives, the difference between earnings and free cash gives us a sense of the cost of growth. For example, let's say free cash flow consistently totals about 60% of net income, while sales and profit growth run about 6%. This suggests that only 40% of earnings will support this growth, leaving the other 60% of net income available for dividends, debt reduction, share buybacks, and other noncore investments. This core growth gives us the second chunk of our total return equation. For CocaCola, let's assume 5.2% growth in operating income over the next five years, and that Coke's growth will fall significantly below that figure thereafter. Assuming that management maintains the current payout ratio, the firm's total dividend payout should rise at a similar clip. So we bolt on this 5.2% growth to our prospective total return, bringing our expectations (including the 2.4% yield noted above) to 7.6%. But we've got one more task before moving on to the third and final stephow much will achieving this 5.2% growth cost? One of the simplest angles is to take the growth we expect (5.2%) and divide that by a representative return on equity (a nifty 30.8% for Coke in the past five years). The resulting ratiocall it "Rcubed" for "required retention ratio"is the proportion of earnings used to fund core growth. For Coke, the R3 is 17% of income, or $0.34 per share. Aftertax return on invested capital is also worth a look. ROIC is actually the purest way of analyzing the incremental cost of growth; in our formula ROIC replaces return on equity in the calculation of R3. However, ROIC is more complex to use, and it leaves out the company's capital structure (mix of additional borrowings and retained earnings) that is reflected in ROE. If the capital structure is stable and returns on equity are consistentCoke checks out here on both countsROE is a good metric to use. We'll stick with ROE R3, and estimate 5.2% annual growth will cost Coke $0.34 per share. Over time the absolute number will grow, but the proportion (17%) will remain the same as long as its two factorsgrowth and return on equitystay the same. Two thirds of the way through our analysis, we're up to a 7.6% return, and we still have $0.56 per share to spare ($2.00 in earnings less $1.10 for the dividend and $0.34 to fund core growth). So what's the final $0.56 per share worth? Next: Evaluate the "Excess" Earnings >> 
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