Risk-avoiding investors looking for stable and regular returns may pick up their choice of stocks using the stable firm test
The growth rate for AM is lower compared to the long run expected growth rate for India.
Investors can be categorised into risk taking and risk avoiding groups. The risk avoiding investors aim to invest in stocks that do not exhibit huge fluctuations in fundamentals. The firms which report stable financials are called stable firms. Let us look at the characteristics of a stable firm.
Higher dividend payout or lower retention rate
Stable firms are those which have a lower need for reinvestment in working capital and capital expenditure. A lower reinvestment need provides them the ability to return a higher portion of the cash flows as dividends to its shareholders. For instance, Abhishek Mahimn Ltd (AM) has a dividend payout ratio (DPR) of 70% in its recent financial year. This indicates that its reinvestment (retention) rate is 30%. This firm is a stable firm as it is reinvesting less and returning more to its shareholders.
No excess returns
Stable firms may not generate excess returns. They report a return on equity which is just enough to cover their cost of equity. This means that these firms earn an industry average profit margin. They have industry average asset turn and equity multiplier. For instance, the ROE of AM is 12% which is equal to its cost of equity of 12 %. Further, the firm’s Dupont components are similar to that of an average firm in its sector.
Lower growth rate
The fundamental growth rate in earnings for equity shareholders could be computed as the product of a firm’s return on equity and its retention rate. Retention rate is calculated by subtracting the dividend payout ratio (DPR) from 1. The fundamental growth rate for AM is 3.60% (= product of ROE of 12% and retention rate of 30%). The growth rate for AM is lower compared to the long run expected growth rate for India.
Higher debt ratio
Stable firms have higher cash flows caused by stable revenue and expense patterns with lower reinvestment needs. This makes them attractive borrowers as they can repay the loans and honour the interest payment obligations in time. Further, stable firms have a compulsion to reduce their cost of capital and therefore their debt equity ratio is normally high. For instance, debt-to-equity ratio of AM is 40%. This reflects that its interest-bearing debt (inclusive of short term and long-term lease obligations) is 40% of its book value of shareholders’ funds.
Equity beta in the range of 0.80-1.20
Stable firms have a levered beta in the 0.80-1.20 range. It is not very high as it is a risk caused by fluctuations in business prospects and operating leverage comes down due to stability in generating and sustaining cash flows. It is not very less as they tend to have higher debt to equity ratio which escalates the impact of financial leverage on the levered beta.
The above stated are the key traits of a stable firm. Risk avoiding investors looking for stable and regular returns may pick up their investment potential using the stable firm test as discussed above.
The writer is associate professor of finance at XLRI – Xavier School of Management, Jamshedpur