What is Sustainable Growth Rate?
The sustainable growth rate is the rate of growth that a company can expect to see in the long term. Often referred to as G, the sustainable growth rate can be calculated by multiplying a company’s earnings retention rate by its return on equity. The growth rate can be calculated on a historical basis and averaged in order to determine the company’s average growth rate since its inception.
The sustainable growth rate is an indicator of what stage a company is in, in its life cycle. Understanding where a company is in its life cycle is important. The position often determines corporate finance objectives such as what sources of financing to use, dividend payout policies, or overall competitive strategy.
The growth ratio can also be used by creditors to determine the likelihood of a company defaulting on its loans. A high growth rate may indicate the company is focusing on investing in R&D and NPV-positive projects, which may delay the repayment of debt. A high growth rate company is generally considered riskier, as it likely sees greater earnings volatility from period to period.
How to Calculate the Sustainable Growth Rate?
The sustainable growth rate is calculated by multiplying the company’s earnings retention rate by its return on equity. The formula to calculate the sustainable growth rate is:
Retention Rate – [ (Net Income – Dividends) / Net Income) ]. This represents the percentage of earnings that the company has not paid out in dividends. In other words how much profit the company retains, where Net Income – Dividends is equal to Retained Earnings.
Return on Equity – (Net Income / Total Shareholder’s Equity). This represents how much return investors have realized relative to the profit the company has generated.
A very high growth rate signifies that a company is still growing very quickly. As such, the company may be spending a lot of its earnings on research and development and may not have a lot of cash left over to make debt payments. Therefore, a growing company could benefit more from equity financing and issuing stock to finance its operations.
Another reason why issuing equity may be a good idea for growing businesses is that growing companies are in a better position to compensate equity investors. Stockholders seek capital gains, meaning that the company does not have to make costly periodic cash payments. It can instead channel funds to business development.
Sustainable Growth Rate Example
Mary’s Tacos wants to calculate its sustainable growth rate for the past few years. Below is a worked example that presents the key inputs to calculate this growth rate for the business:
As we can see, the sustainable growth rate of Mary’s Tacos hovers around the 10% mark.
To better understand the financial health of the business, the sustainable growth rate should be computed for a number of companies that operate in the same industry. If some other firms operating in this industry see ratios that are, on average, lower than Mary’s, we can conclude that the business is growing quickly and outperforming its competition.
This would imply that it may be best for Mary’s to utilize equity financing over debt financing, due to the cash flow constraints that come with interest payments. Mary’s may also choose to pursue a more aggressive corporate development strategy in order to sustain its growth and further penetrate the market.
We hope you enjoyed CFI’s explanation of sustainable growth rate. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: