Equity Growth Rate
The term equity growth rate refers to a measure that allows the investor-analyst to understand the amount of funds being added to equity by operations. The equity growth rate metric allows shareholders to understand if the company's equity pool is increasing or decreasing over time.
Equity Growth Rate = (Net Income - Stock Dividends) / Stockholders' Equity Assets
- Stock dividends refers to those issued to both holders of common and preferred shares.
- Stockholders' equity is the dollar value of this account at the beginning of the accounting period.
Return on investment measures allow the investor-analyst to understand the company's ability to provide shareholders with an acceptable return on their investment. This is usually assessed by examining metrics such as net worth, returns on equity or assets, earnings, economic value added, and dividends. Return on investment metrics provide analysts with a way to determine a fair price to pay for a share of common stock. One of the ways to understand if stockholders' equity is growing or shrinking is by calculating a company's equity growth rate.
Investors in common stock are the owners of a company, and as such, they will be concerned with the amount of equity they have in the business. When a company generates profits (in terms of net income), this money belongs to the holders of common stock. The company's board of directors are responsible for determining what to do with this money. For example, they might return some of the profit to stockholders in the form of a dividend. Companies competing in more established industries will tend to retain some profit to fund growth and return some of the profit to shareholders in the form of a dividend. Companies competing in growth industries may decide to retain all earnings.
Retained earnings is different than stockholders' equity, since the latter is net of all money owed to lenders. For this reason, stockholders' equity is believed to be a good measure of the company's value. A company's equity growth rate is found by subtracting dividends from net income and dividing the resultant value by the total of stockholders' equity at the beginning of the same accounting period.
A mutual fund manager would like to better understand the value of Company ABC to shareholders prior to investing in the company. He asked his analytical team to calculate Company ABC's equity growth rate last year. The team examined both the company's income statement as well as its balance sheet. Stockholders' equity can be found by subtracting liabilities from assets - this is why it's considered the book value of the company. The manager's team pulled the information below from both the company's balance sheet and income statement:
Net Income = $7,490,000Stock Dividends = $1,498,000Stockholders' Equity = $37,500,000
Company ABC's equity growth rate would then be:
= $7,490,000 - $1,498,000 / $37,500,000= $5,992,000 / $37,500,000, or 16.0%