Sustainable Growth Rate

A company’s rate of growth that can be achieved using internally generated funds (i.e., without new external financing). This rate thus depends on:

• Its return on equity

$$ROE=\frac{\text{Net Income}}{\text{Book Value of Equity}}$$

• The proportion of earnings that are retained and reinvested in the firm, i.e. no paid out as dividends (the retention ratio)

$$\text{Retention Ratio}=(1-\text{Payout Ratio})=1-\frac{\text{Dividend per share}}{\text{Earnings per share}}$$

Then we conclude:

$$\text{Sustainable growth rate}=ROE\times \text{Retention Ratio}$$

Example

If a company pays out 40% of Net Income as dividends, then its retention ratio is 60%

• If the ROE is 8%, what is sustainable growth rate $g$?

$$g=0.08\times 0.60=0.048=4.8\%$$