Costco - Sustainable Growth Model, 1997-2001

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 ROE is up approximately $0.13 from five years ago. This indicates good company performance.

Step 2: Leverage

The ROE can be further broken down into three separate areas. One area is financial leverage. Issuing debt allows Costco to increase its return on equity as long as the return on invested capital is greater than the cost of debt. If Costco's core business earns 12% return on invested capital but it can borrow the debt at a lower rate, financial leverage would increase the ROE. Financial leverage is expressed as the ratio:

∑ Assets-to-Equity = Assets / Owners Equity

Costco's assets-to-equity ratio has fallen slightly from 2.21 to 2.06. This means that for every dollar of invested capital Costco acquires $2.06 worth of assets in 2001 verses $2.21 worth of assets in 1997. This may indicate that less assets are being acquired. If less assets are acquired, less sales may be generated and if less sales are generated there is less net income yielding less return for shareholders and a less attractive investment opportunity.

Wal-Mart Corp has had very inconsistent asset-to-equity ratio form year to year which makes it difficult to draw any conclusion regarding investment. Such inconsistency could be an indication of

Sears asset-to-equity ratio had been consistent decreasing from 6.60 to 5.45 until 2001 when it increased to 7.24. This is the highest ratio of any Costco competitor. Although this ratio is high, the instability of the number over the periods measured may discourage investment.

BJ's Wholesale has demonstrated overall growth in asset-to-equity ratio from 1.81 to 2.07 over the five years measured. This may be an indication of an attractive company to invest in because the ratio is increasing which means there may be increasing returns to investors.

Note that the lower asset-to-equity ratios of Costco, Wal-Mart Corp and BJ's Wholesale could indicate they are growing companies that are using increased equity to fund expansion. This could keep the asset-to-equity ratio down until the rate of expansion decreases. It would also support the earlier statement that Costco and Wal-Mart Corp are rapidly growing companies.

Assets represent the sum of capital Costco uses at any given time. Thus, return on assets (ROA) is a measure of Costco's overall profitability that makes no distinction between funding from shareholders or funding from creditors. ROA