Sustainable Growth Rate: While investing in a company, one of the most critical factors to look at is its growth rate. At what percentage the company is estimated to grow in the upcoming years? This is because, as the company grows & generate more profits, generally, your investment will grow along with it. Moreover, it’s not a viable strategy to invest in declining companies or the ones with no significant growth aspects.
But how to calculate the growth rate of a company?
A common approach that most investors follow is to look into the historical growth rate. Here, they try to find out the rate at which revenue, earnings, etc are historically growing, to assume a similar growth rate in the future.
Although past performance doesn’t guarantee future growth, however, it can give you a rough estimation if you expect the company to perform similarly in the future. Here, investors can use the compounded annual growth rate approach to define growth.
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However, forecasting growth based on such estimations may not always be valid. Besides, the estimates can change depending on the ‘number of years that you’re considering. For example, the past 3-years, 5-years, and 10-years historical growth rates might be totally different. Which one should the investors focus on while forecasting the future?
A better approach while studying growth is to look into the sustainable growth rate (SGR) of a company that focuses on different factors like earnings, shareholder’s equity, payout, etc to find out the growth percentage of a company. But what exactly is a sustainable growth rate? This is what we are going to discuss in this post.
Sustainable Growth Rate (SGR)
The sustainable growth rate is the maximum growth rate that a company can sustain using its own resources i.e. without financing the growth using debt or equity dilution. It is calculated as:
Sustainable Growth Rate (SGR) = ROE * Retention Rate (RR)
Return on Equity(ROE): ROE is the amount of net income returned as a percentage of shareholders’ equity. It can be calculated as: ROE= (Net income/ average stockholder equity). ROE shows how good is the company in rewarding its shareholders. A higher ROE means that the company generates a higher profit from the money that the shareholders have invested.
Retention Rate (RR): This is the percentage of net income that is retained to grow the business, rather than being paid out as dividends. Retention rate is calculated as: RR= (1 — Payout ratio) = ( 1 — DPS/EPS), where DPS is the dividend per share and EPS is earnings per share.
For example, if a company ABC has a ROE of 15% and payout ratio of 40%, then its sustainable growth growth rate can be calculated as: SGR = 15 * ( 1–0.4) = 15 * 0.6 = 9%.
Ideally, the growth of a company funded by its own resources is the best form of growth compared to any other leveraged growth option. The latter scenario may lead to financial stress and in the worst case, bankruptcy.
Moreover, any company can grow faster if it takes a lot of debt and spends on marketing, new product development, acquisitions, etc. However, returning that debt can be a troublesome process if it’s business model is not that strong.
By looking into the SGR of a company, Investors can find out its long-term growth, current life cycle stage, cash flow projections, borrowing & dividend allocation strategies, etc.
According to the sustainable growth rate formula, SGR = ROE * RR = ROE* (1 – Payout Ratio)
Here, when the payout ratio is zero, the SGR becomes equal to the ROE of the company. You can maximize the sustainable growth rate by increasing ROE or decreasing payout (i.e. retaining more earnings rather than paying out as dividends).
Technically, a few ways to maximize SGR is by increasing sales & profit margin, managing account payable & receivables, efficient inventory management, etc. However, a point to note here is that a high SGR is always difficult to maintain. As the company matures, it cannot sustain similar high past growth rates.
An efficient management’s goal is to grow the company at its sustainable growth rate. If the SGR is 15%, the company can safely grow at this percentage per annum without taking any additional financial leverage. It can be considered the ceiling growth rate of a company while using its own resources.