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What is the Sustainable Growth Rate?

Sustainable Growth Rate

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Sustainable Growth Rate

The Sustainable Growth Rate (SGR) is a metric used to determine the maximum rate at which a company can grow its sales, assets, and earnings without issuing new equity or taking on additional debt. It’s a measure of how fast a company can grow using internally generated assets without resorting to external financing.

The formula to calculate the Sustainable Growth Rate is:

SGR = ROE × Retention Ratio

Where:

  • ROE (Return on Equity) is the net income divided by shareholders’ equity. It represents the return a company is generating on its equity capital.
  • Retention Ratio (also known as the plowback ratio) is the portion of net income that is retained in the business rather than paid out as dividends. It can be calculated as 1 − Dividend Payout Ratio.

The intuition behind the formula is straightforward:

  • The ROE indicates how effectively a company is generating profit from its equity.
  • The retention ratio tells us how much of that profit the company is reinvesting (or “retaining”) in the business.

Multiplying them gives us an estimate of the growth rate achievable with the profits being reinvested.

Example of the Sustainable Growth Rate

Let’s walk through a hypothetical example to illustrate how the Sustainable Growth Rate (SGR) is calculated for a company.

Scenario:

You are analyzing “TechNovel Corp.”, a technology company. From the annual report, you gather the following information:

  • Net Income for the year: $1,000,000
  • Shareholder’s Equity: $5,000,000
  • Dividends paid: $200,000

Step 1: Calculate the Return on Equity (ROE)

ROE = Net Income / Shareholder’s Equity

ROE = $1,000,000 / $5,000,000 = 0.20

This means the ROE is 20%.

Step 2: Calculate the Dividend Payout Ratio and the Retention Ratio

Dividend Payout Ratio = Dividends paid / Net Income
Dividend Payout Ratio = $200,000 / $1,000,000 = 0.20

Given the Dividend Payout Ratio is 20%, the Retention Ratio is:
Retention Ratio = 1 − Dividend Payout Ratio = 1 − 0.20 = 0.80

This means the company retains 80% of its earnings.

Step 3: Calculate the Sustainable Growth Rate (SGR)

SGR = ROE × Retention Ratio
SGR = 0.20 × 0.80 = 0.16

The SGR is 16%.

Conclusion:

TechNovel Corp. can sustainably grow its earnings and assets at a rate of 16% per year without needing to secure external financing, given its current financial structure and dividend policy.

This analysis can aid investors and company management in making informed decisions about financing and growth strategies.

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