Sustainable Growth Rate: Concept

We have studied the various discounted cash flow valuation models in this module. These different models need to be applied in different situations. We have studied these situations as well. However, regardless of which model is being applied, one thing remains constant.

In the end, the growth rate of the company plateaus down at a certain level. It can continue at this rate forever, meaning that it is “sustainable”. Now, since terminal value is the most important component of valuation and since sustainable growth rate is an important determinant of terminal value, we need to understand the concept of sustainable growth rate in detail.

This article will explain this concept of sustainable growth rate in detail.

What is Sustainable Growth Rate?

In jargonized terms, sustainable growth rate is the rate at which the earnings and dividends of any firm can continue to grow indefinitely. The implicit assumption behind sustainable growth rate is that no new debt or equity is being issued and that the capital structure of the firm remains unchanged.

In this case, the sustainable growth rate possible in any organization remains a simple function of the proportion of earnings that are retained and reinvested in the business as well as the returns that can be generated from those earnings.

Simply put:

Sustainable Growth Rate = b * ROE

Where,

b = the reinvestment rate which is being followed by the organization

ROE is the Return on Equity which is earned by the organization

Why Is It Important To Calculate Sustainable Growth Rate?

The calculation of sustainable growth rate is important because it answers two very important questions:

1. It lets the analysts and the investors know the maximum possible rate at which the organization can grow. This is under the assumption the no additional funding is being raised either by debt or by equity
2. Secondly, this rate also provides an estimate when it comes to raising external capital. It provides a guideline as to how much funds should be obtained and on what terms.

Sustainable growth rate is basically a link between the nature of the current operations of a firm and its future valuation.

Example:

To understand the concept of sustainable growth rate better, let’s have a look at an example.

Let’s say that a company pays out 40% of its earnings as dividends each year. Also, historically it has been making a stable return on equity at 15%. What is the sustainable growth rate for this company?

Answer:

Since the company pays out 40% of its earnings as dividends, it is implied that it retains the balance 60% for reinvestment. Hence b = 0.6 i.e. 60%. At the same time, ROE is stated to be 15%.

Therefore, the sustainable growth rate which the company can finance through its internal accruals is 15% *0.6 = 9%.

Hence with this capital structure and this dividend policy, the company can continue to grow at the rate of 9% forever.

Interpretation:

Now, since we know the sustainable growth rate, how do we include it in our decision making? Here is an example for the same:

• Growth rate expected to be greater than sustainable growth rate: Let’s say that the company is expecting to grow at 14% for the next few years. However, its sustainable growth rate shows that it can sustain only 9% if its policies remain unchanged. This analysis will provide a clear indication to the management that their plans are off base when compared to reality. To grow at 14% given the current scenario, the company would have to reduce dividends, raise more capital or both. This analysis provides a double checking mechanism for checking the validity of the future plans of the company
• Growth rate expected to be lesser than sustainable growth rate: On the other hand, let’s say given the current market condition, the management foresees that the organization will only be able to grow at the rate of 7%. However, the sustainable growth rate analysis suggests that 9% growth is possible given the current policy. In such a case, management may decide to increase their dividend payouts.

Hence, the bottom line is that a comparison between the sustainable growth rate and the expected future growth rate provides guidelines based on which policies pertaining to raising capital and changing the dividend payout must be built.