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Sustainable Growth Rate

Evaluating how quickly a business is growing year-over-year

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.  Such a growth rate can be calculated on a historical basis and averaged in order to determine the company’s average growth rate since inception.

The Sustainable Growth Rate is an indicator of what stage a company is currently in in its life cycle. Understanding where a company is in its life cycle is very important since this will determine a variety of corporate finance objectives such as what sources of financing to use, dividend payout policies or overall competitive strategy.

This ratio can also be used by creditors in order to determine the likelihood a company has of defaulting on its loans. A high growth rate could indicate that the company is focusing on investing in R&D and pursuing NPV-positive projects; which may delay the repayment of debt. A high growth rate company is generally also considered more risky as it likely sees greater earnings volatility from period to period.

 

Sustainable Growth Rate Summary

 

How can we calculate the Sustainable Growth Rate?

Sustainable growth rate can be calculated by multiplying the company’s earnings retention rate by its return on equity. The formula to calculate the sustainable growth rate is:

 

Sustainable Growth Rate Formula

 

Where:

Retention Rate – (Net Earnings – Dividends Declared / Net Earnings). This represents the percentage of earnings that the company has paid out in dividends.

Return on Equity – (Net Earnings / Total Shareholder’s Equity). This represents how much return the company has realized relative to the profit it has generated.

A very high growth rate would signify that the company is still growing very quickly. As such, the company may be spending a lot of its earnings into 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 would be a good idea for growing businesses would be 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, and can instead channel funds to business development instead.

 

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:

 

Sustainable Growth Rate Example

 

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 and compared. If some other firms operating in this industry see ratios that are, on average, lower than Tim’s, we can conclude that Mary’s is growing fairly quickly. 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  purse a more aggressive corporate development strategy in order to sustain its growth and further penetrate the market.

 

Additional Resources

Thank you for reading this article! 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:

 

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