The sustainable growth rate is the fastest a business can grow on its own retained profit, without increasing financial leverage and without raising money from outside. Farm-management research states it in exactly those terms, defining it as the maximum rate of growth that a farm can sustain without having to increase financial leverage or look for outside financing (Purdue University, What is My Sustainable Growth Rate?). It is return on equity multiplied by the share of earnings the business keeps, and the whole number turns on the two things it refuses to change. Let the owner borrow more, or sell more shares, and a faster rate becomes available and the measure stops answering the question it was asked.
The Two Constraints Are the Measure
Growth funded from the outside is not what this rate reports. The definition rules out increasing financial leverage and rules out outside financing, so the only money available for growth is the profit that was not taken out.
The equity model behind the corporate version makes the second constraint explicit. Under the simplest relationship determining growth, one based upon the retention ratio, meaning the percentage of earnings retained in the firm, and the return on equity on its projects, the return on equity is assumed unchanged and the firm is not being allowed to raise equity by issuing new shares (Aswath Damodaran, NYU Stern, The Fundamental Determinants of Growth). Because no shares are issued, the growth rate in net income and the growth rate in earnings per share are the same figure in that formulation.
So the rate is a statement about a business financing itself. It is not a forecast, and it is not a ceiling anyone is obliged to respect.
The Formula and Its Two Inputs
sustainable growth rate = return on equity x retention ratio
retention ratio = 1 - dividend payout ratioBoth inputs are already measures in their own right. Return on equity puts the period’s profit over the equity that produced it. The retention ratio is the complement of the payout ratio, the share of the period’s profit kept in the business rather than distributed, and how it sits against the rest of that family is worked through in dividend ratios and dividend payout ratio.
Because the two multiply, a business can reach the same growth rate from opposite directions. High returns paid mostly out, or modest returns kept almost entirely in, land in the same place.
What the Arithmetic Looks Like
Three real companies, with the returns on equity, retention ratios and resulting expected growth rates set out side by side (Aswath Damodaran, NYU Stern, The Fundamental Determinants of Growth).
return on equity retention ratio expected growth
Consolidated Edison 11.63% 29.96% 3.49%
Procter & Gamble 29.37% 49.29% 14.48%
Reliance Industries 19.43% 82.57% 16.04%The middle two columns multiply to the third in every row. Reliance reaches the highest growth of the three without having the highest return on equity, because it keeps more than four fifths of what it earns. Consolidated Edison earns a respectable return and pays out about seven tenths of it, so almost nothing is left to compound.
The Owner-Operated Version
A business without shareholders or dividends computes the same idea from withdrawals. The sustainable growth rate is net farm income less owner withdrawals, divided by owner’s equity or net worth, and net farm income minus owner withdrawals is what represents retained earnings (Purdue University, What is My Sustainable Growth Rate?). Owner withdrawals, family living expenses among them, do the work the payout ratio does in a business that pays dividends. The same source sets one limit on what the measure covers: the sustainable growth rate and return on equity as computed there do not include capital gains on land (Purdue University, What is My Sustainable Growth Rate?).
The same source runs the sensitivity across both inputs. The sustainable growth rate ranges from 0.01, or 1 percent, for a return of 4 percent with 75 percent of income withdrawn, to 0.06, or 6 percent, for a return of 8 percent with 25 percent withdrawn (Purdue University, What is My Sustainable Growth Rate?). Doubling the return and cutting the withdrawal rate to a third of itself moves the growth rate by a factor of six.
What Leverage Does to It
The rate holds leverage fixed, which raises the obvious question of what happens if it is not.
The impact of financial leverage on return on equity and on the sustainable growth rate depends on the relationship between return on assets and the interest rate on borrowed funds. As long as return on assets is larger than the interest rate on borrowed funds, financial leverage will increase the return on equity and the sustainable growth rate, but higher financial leverage leads to an increase in financial risk (Purdue University, What is My Sustainable Growth Rate?). Specifically, as financial leverage increases, the potential loss of equity increases, the variation in expected returns to equity increases, and the liquidity provided by credit reserves, meaning the difference between a farm’s operating line limit and operating funds borrowed, lessens.
That is the trade the measure is built to expose. A faster growth rate is always purchasable, and the price is stated in risk rather than in the growth number.
The identity behind the leverage half of that, and why the assets-over-equity form and the debt-to-equity form are one fact stated twice, is in equity multiplier.
What It Is Not
- A forecast. It reports what the current return and the current payout policy would support, not what will happen.
- A limit on how fast a business may grow. Growing faster is possible. It requires borrowing, or issuing equity, and both are outside what the rate measures.
- A measure of profitability. Two businesses with the same return on equity can have very different sustainable growth rates, and the entire difference is what the owners took out.
Common Questions
Return on equity multiplied by the retention ratio, where the retention ratio is one minus the dividend payout ratio.
Either input. A higher return on equity, or a smaller share of profit taken out of the business. Because they multiply, an improvement in one is diluted by weakness in the other.
Because that assumption is what makes the answer a statement about internal funding. In the model the firm is not being allowed to raise equity by issuing new shares, which is also why the growth rate in net income and the growth rate in earnings per share come out identical.
Yes, wherever the business loses money or distributes more than it earned. The arithmetic follows the retained amount, and a retained amount below zero is equity leaving the business.
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