Your Money: Knowing the Five Characteristics of a Stable Business
Investors can be classified into risk taking and risk avoidance groups. The risk avoided to investors aims to invest in stocks that do not exhibit huge fluctuations in fundamentals. Firms with stable financial statements are called stable firms. Let’s take a look at the characteristics of a stable business.
Higher dividend payout or lower retention rate
Stable businesses are those with a lower need for reinvestment in working capital and capital expenditure. A lower reinvestment need gives them the opportunity to return a higher portion of the cash flow as dividends to its shareholders. For example, Abhishek Mahimn Ltd (AM) has a dividend payout ratio (DPR) of 70% in its last fiscal year. This indicates that its reinvestment (retention) rate is 30%. This company is a stable company because it reinvests less and returns more to its shareholders.
No excess returns
Stable businesses may not generate excess returns. They are earning a return on equity that is just sufficient to cover their cost of equity. This means that these companies earn an industry average profit margin. They have an average asset turnover and a stock multiplier. For example, AM’s ROE is 12%, which is equal to his cost of equity of 12%. In addition, the Dupont components of the company are similar to those of an average company in its sector.
Lower growth rate
The fundamental growth rate of shareholder earnings could be calculated as the product of a company’s return on equity and its retention rate. The retention rate is calculated by subtracting the dividend payout ratio (DPR) from 1. The fundamental growth rate for AM is 3.60% (= product of 12% ROE and 30% retention rate). The growth rate of AF is lower than the expected long-term growth rate for India.
Higher debt ratio
Stable businesses have higher cash flow due to stable income and expense models with lower reinvestment needs. This makes them attractive borrowers because they can repay loans and meet interest payment obligations on time. In addition, stable firms are forced to reduce their cost of capital and hence their debt ratio is normally high. For example, AM’s debt-to-equity ratio is 40%. This reflects that its interest-bearing debt (including short-term and long-term lease obligations) represents 40% of its book value of shareholders’ funds.
Beta of stocks between 0.80 and 1.20
Stable companies have a leveraged beta of between 0.80 and 1.20. It is not very high as it is a risk caused by fluctuations in business prospects and operating leverage decreases due to the stability in generating and maintaining cash flow. It’s not much less as they tend to have a higher leverage ratio, which intensifies the impact of leverage on leveraged beta.
The above are the key characteristics of a stable business. The risk of avoiding investors looking for stable and consistent returns can increase their investment potential by using the stable firm test as discussed above.
The writer is Associate Professor of Finance at XLRI – Xavier School of Management, Jamshedpur