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Subject 9. Sustainable Growth Rate PDF Download
Frequently, analysts are interested whether a certain growth rate is sustainable in the long run, that is, whether a company can grow at this rate indefinitely in the future without changing the capital structure. Such rate may be used as a proxy for the mature growth rate for a company. Sustainable growth rate can be estimated using the following formula:

g = b x ROE

where b is a retention rate, and ROE is the return on equity.

Earnings and dividends grow at the rate g indefinitely, provided that two assumptions hold:

  • If a company issues new debt at the same rate g to maintain constant capital structure (remember that a part of earnings is retained every year, adding to equity);
  • ROE and dividend payout rate are constant.

We have already discussed the DuPont system for calculation of ROE previously. The simple DuPont formula decomposes ROE into three ratios, characterizing company profitability, operating efficiency, and financial structure:

Return on Equity = Profit Margin x Total Asset Turnover x Financial Leverage
= Net Income / Sales x Sales / Total Assets x Total Assets / Common Equity

If we multiply both sides by retention ratio, we can analyze the sustainable growth rate based on the ratio analysis:

Sustainable Growth Rate = (Net Income - Dividends) / Net Income x Net Income / Sales x Sales / Total Assets x Total Assets / Common Equity.

Earnings retention ratio and equity multiplier describe the financing decisions of a company. Net profit margin and total assets turnover characterize the profitability and operating efficiency of a company (note that the product of the two ratios is return on assets, ROA).

User Contributed Comments 2

User Comment
joywind those indefinite growth dreams should end now... nothing last forever...
TheCFAGuy what you on about joywind?

if you're saying that one day the world will end and so growth technically isn't indefinite then ok - you're just being unnecessarily dark. but i think you're criticising the current model we have for understanding global economics, by saying "we can't keep squeezing growth out of the economy" - again pessimistic, but also misinformed.

given that:
1. technological development increases the economy's productivity per unit of input, it also increases the present value of the economy's potential production (even if current inputs of labour and capital do not increase); and
2. the pace of technological development over the past 300 years has been accelerating..

..i think it's safe to say that unless technological development stops dead in its tracks (i.e. no more inventions) then the the present value of the economy will continue to grow. and this is why we assume a sustainable growth model when looking at the economy.

you're not smarter than generations of well studied economists applying science to the question of economic growth joywind. you're just a pessimist who is not applying science.
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Your review questions and global ranking system were so helpful.


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