Sustainable Growth Rate

Sustainable growth rate (SGR) is the maximum growth rate that a company can achieve using its retained earnings while also maintaining its capital structure i.e. its mix of debt and equity. Sustainable growth rate is calculated as the product of return on equity and the company retention rate (i.e. 1 – dividend payout ratio).

A company can expand its capacity and increase its sales by expanding its asset base. This increase can be funded by using the earnings or by raising external financing, i.e. issuing bonds or common stock. While using retained earnings there are two further options: (a) solely using the net income retained to fund assets and sales growth or (b) using the retained earnings while also allowing for additional borrowing such that the proportion between debt and equity in the company’s capital structure is maintained. The maximum growth rate in the first option is called internal growth rate while the growth rate that can be achieved using internal financing while maintaining capital mix, as in the second option, is called sustainable growth rate.

Formula

If we want an increase in growth rate while also maintaining the equity and debt mix, the absolute dollar growth in equity must equal the reinvested earnings. The growth rate in equity can be defined as follows:

$$ Sustainable\ Growth\ Rate\\=\frac{Reinvested\ Earnings}{Equity} $$

Reinvested earnings equal net income multiplied by (1 – dividend payout ratio).

$$ Sustainable\ Growth\ Rate\\=\frac{Net\ Income\ \times(1−Dividend\ Payout\ Ratio)}{Equity} $$

$$ Sustainable\ Growth\ Rate\\=\frac{Net\ Income\ }{Equity}\times(1−Dividend\ Payout\ Ratio) $$

Net income divided by equity equals return on equity (ROE):

$$ Sustainable\ Growth\ Rate\\=ROE\times(1−Dividend\ Payout\ Ratio) $$

The above equation is the formula for sustainable growth rate.

Example

You have the following information about General Motors (GM) for FY 2016:

Total assets $221,690 million
Total liabilities $177,854 million
Net income for the period $9,427 million
Dividends paid $2,239 million

Calculate the company’s sustainable growth rate and work out the company’s new asset, liabilities and equity level if the sustainable growth rate is achieved.

First, we need to find out return on equity and dividend payout ratio.

$$ Return\ on\ Equity\\=\frac{$9,427\ million}{$221,690\ million−$177,854\ million}\\=21.51% $$

$$ Dividend\ Payout\ Ratio\\=\frac{$2,239\ million}{$9,427\ million}\\=23.75% $$

$$ Sustainable\ Growth\ Rate\\=21.51%\times(1−23.75%)\\=16.40% $$

If the sustainable growth rate is achieved, the company’s new liabilities, equity and asset levels will be as follows:

Assets $258,042 = $221,690 × (1 + 16.40%)
Liabilities $207,018 = $177,854 × (1 + 16.40%)
Equity $51,024 = $43,866 × (1 + 16.40%)

The whole increase in equity will come from internal sources while the company may raise debt equal to (=$207,018 − $177,854). It is called sustainable growth rate because this can be achieved without burdening the company with too much debt relative to assets and equity.

Written by Obaidullah Jan, ACA, CFA and last modified on