What is the Sustainable Growth Rate Formula?
Sustainable growth rate (SGR) signifies how much the company can grow sustainably in the future without relying on external capital infusion in the form of debt or equity and is calculated using the return on equity (which is the rate of return on the book value of equity) and multiplying it by the business retention rate (which the proportion of earnings kept back in the business as retained earnings).
- Return on equity is the percentage of earnings for a period of a company with respect to the equity invested in the company. Return on equity is arrived at by dividing earnings from equity.
- Retention ratio is the percentage of earnings that the company retains for its use and future growth of the company. Retention amount is the residual amount after the amount paid from earnings as a dividend.
- RR= Retention ratio
- ROE= Return on Equity
It is the operational growth rate, achieved without taking into consideration the borrowed funds in the form of debt by the company. That’s why this ratio is considered to be sustainable as this much the company will be able to grow even without taking any outside debt investments.
It is the growth achieved by a company with the help of the earnings it decides to retain after distributing the amount of money the shareholders in the form of a dividend. An analyst looking at sustainable growth rate ratio will look for a higher ratio as it signifies a better future prospect for the company.
Examples of Sustainable Growth Rate Formula (with Excel Template)
Let’s see some simple to advanced examples to understand it better.
Let’s assume some numbers in the table below for the calculation of the sustainable growth for two companies. Calculate the sustainable growth rate for these two arbitrary companies.
For the calculation of sustainable growth rate, we need the return on equity of a company and retention ratio which is calculated by deducting the dividend amount payable from the earnings of the company and dividing that numerator by net income available to the shareholders.
Retention ratio for Company A
RR= 1- (dividends paid/earnings)
- Retention ratio for Company A= 1- (1.5/4)= 0.63
Retention Ratio for Company B
- Retention ratio for Company B= 1- (2/5) = 0.60
Therefore the calculation of the Sustainable Growth Rate equation for company A is as follows,
- Sustainable growth for company A = 14%*.63
Sustainable Growth Rate for company A
- Sustainable growth for company A= 8.8%
Therefore the calculation of Sustainable growth rate for company B is as follows,
- Sustainable growth for company B = 10%*0.60
Sustainable Growth Rate for Company B
- Sustainable growth for company B= 6.0%
Calculate the Sustainable growth rate for Reliance Industries. The table below depicts the dividend, earnings per share and the return on equity for reliance industries.
Retention Ratio for Reliance Industries
- Retention ratio for Reliance Industries = 1- (6/56) =0.89
Therefore the calculation of SGR formula is as follows,
- Sustainable growth for Reliance Industries = 12%*.89
The sustainable growth rate for Reliance Industries
- Sustainable growth for Reliance Industries = 11%
Higher the rate of Sustainable growth better it is for the company, the ratio signifies for a company that how much the company can grow sustainably in the future with the number of earnings it is generated with the help of normal course of business. The ratio for reliance industries signifies that reliance industries are able to grow by 11% on a sustainable basis in the future.
The table below depicts the dividend, earnings per share and the return on equity for Tata Steel.
Retention ratio for Tata Steel
- Retention ratio for Tata Steel = 1- (9.4/75) =.87
Therefore the calculation of the SGR formula is as follow,
- The sustainable growth for Tata Steel = 23%*0.87
The SGR for Tata Steel
- The sustainable growth for Tata Steel = 20%
Higher the rate of SGR better it is for the company, the ratio signifies for a company that how much the company can grow sustainably in the future with the number of earnings it is generated with the help of normal course of business. The ratio for Tata Steel signifies that Tata Steel is able to grow by 20% on a sustainable basis in the future.
Sustainable growth rate Calculator
You can use the following SGR Formula Calculator.
|Sustainable Growth Rate Formula =||Retention Ratio x Return on Equity|
|0 x 0 =||0|
Relevance and Uses
Sustainable growth is a very important ratio to find out the future prospect of a company. Analysts who analyze the company keep a very close look at the ratio. The ratio is arrived at by using two very important parameters which the return for the equity shareholders of the company. And the second variable used for calculating the SGR Formula is the retention ratio.
It is desirable to have both a higher ratio for return on equity as that signifies higher earnings on the same level of equity investments and also a higher level of retention ratio. If a company is maintaining a higher level of retention ratio it signifies that the company has future growth prospect and is confident of generating a higher return with the money it is willing to retain. The reason for which return on equity is used as a variable for the ratio is that it directs towards the operational growth of the company which is attained without the use of financial leverage.
This has been a guide to Sustainable Growth Rate Formula. Here we discuss how to calculate Sustainable Growth Rate along with some practical examples and downloadable excel template. You may learn more about Valuation Analysis from the following articles –