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Financial Forecastingintermediate

Sustainable Growth Rate

The sustainable growth rate is the pace at which a firm can grow using only retained earnings, without issuing new equity and while holding its capital structure and operating ratios fixed. It equals the retention ratio times return on equity, g=b×ROEg = b \times ROE, where bb is the fraction of earnings ploughed back. The idea disciplines a forecast in two ways. It links growth to the reinvestment that funds it, so growth is not assumed for free, and it flags when a planned growth rate would force the firm to raise outside capital, which the pro-forma must then explicitly finance.

Why it matters

Growth has to be paid for. A firm that distributes all its profit cannot grow its equity base internally, while one that retains and reinvests at a high return can compound quickly. The product of how much it keeps and how well it reinvests sets the speed it can sustain on its own. The number is a reality check on the sales forecast. If the plan calls for growth above the sustainable rate, the firm is implicitly promising to raise new equity or lever up, and the pro-forma plug should show that financing need rather than pretend the growth funds itself. Growth beyond reinvestment is never free.

Formulas

Sustainable growth rate
g=b×ROEg = b \times ROE
Here bb is the retention ratio, one minus the dividend payout, and ROEROE is return on equity. This is the growth in equity financeable purely from retained earnings.
Retention and payout
b=1−DivNIb = 1 - \dfrac{Div}{NI}
The retention ratio is the share of net income kept rather than paid out. A firm that retains more, or earns a higher return on equity, can sustain faster internally funded growth.

Worked examples

Scenario

A firm earns a return on equity of 15 percent and pays out 40 percent of its earnings as dividends. What growth can it sustain internally, and what does it imply if management forecasts 12 percent sales growth?

Solution

The retention ratio is one minus 0.40, which is 0.60. The sustainable growth rate is 0.60 times 15 percent, which is 9 percent. The firm can grow about 9 percent a year on retained earnings alone while holding its leverage and ratios steady. A 12 percent forecast sits above this, so the plan cannot fund itself internally. To reach 12 percent the firm must raise external capital, cut the dividend to lift retention, or earn a higher return on equity. The honest pro-forma shows that financing gap in the plug rather than assuming the extra growth appears for nothing.

Common mistakes

  • ✗A firm can grow at any rate without raising capital. Internally funded growth is capped at the retention ratio times return on equity. Faster growth requires outside financing.
  • ✗Paying higher dividends has no effect on sustainable growth. A higher payout lowers retention, which directly lowers the growth a firm can fund from its own earnings.
  • ✗Sustainable growth equals current revenue growth. The two often differ. When realised growth exceeds sustainable growth, the firm is leaning on external capital, which the forecast must finance.
  • ✗A high return on equity always means safe growth. Return on equity can be inflated by leverage, so growth funded by an already-stretched balance sheet may not be sustainable in practice.

Revision bullets

  • •Sustainable growth is the rate financeable from retained earnings alone
  • •Equals the retention ratio times return on equity, g = b times ROE
  • •Assumes capital structure and operating ratios stay fixed
  • •Higher payout lowers retention and so lowers sustainable growth
  • •Growth above the sustainable rate forces external financing
  • •The pro-forma plug should show that financing need explicitly

Quick check

A firm with a return on equity of 20 percent that retains 50 percent of earnings has a sustainable growth rate of

If a firm forecasts sales growth well above its sustainable growth rate, it implies that

Connected topics

Pro-Forma StatementsSales DriversNWC & CapexFinancing PlugROIC vs WACC

Sources

  1. Titman & Martin, Ch. 6
    Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.
    Links forecast growth to the reinvestment that funds it and to the firm’s external financing requirement.
  2. Koller, Goedhart & Wessels (2020), Ch. 13
    Koller, T., Goedhart, M., & Wessels, D. Valuation: Measuring and Managing the Value of Companies. 7th ed. McKinsey & Company / Wiley, 2020.
    Treats internally financeable growth and the reinvestment needed to sustain a growth forecast.
  3. Connected research
    Stock Return Volatility and Financial Distress: Moderating Roles of Ownership Structure, Non-financial Constraints, and Managerial Ability. International Review of Economics and Finance, 2024.
    On the managerial-ability strand, evidence that the quality of management shapes the return on equity and reinvestment efficiency that drive sustainable growth.
How to cite this page
Dr. Phil's Quant Lab. (2026). Sustainable Growth Rate. Derivatives Atlas. https://phucnguyenvan.com/concept/sabv-sustainable-growth-rate
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