What is the Sustainable Growth Rate (SGR)?

Last Updated: 1 Sep 2022

Growth is inevitable to survive in the market for the long term. Analyzing the future growth potential of the company, before investing, is not just important, but rather indispensable. Investors often invest in companies with enough potential to expand operations through their profits. Some of the metrics in the hands of investors to evaluate the growth potential of the company are the Price-to-earnings growth (PEG) ratio, Internal growth rate (IGR), and Sustainable Growth Rate (SGR).

This article provides information on the Sustainable Growth Rate meaning, how it is calculated, its example, and the difference between SGR and PEG.

What is the Sustainable Growth Rate?

A sustainable growth rate refers to the maximum growth rate an organization can attain with existing resources, or without acquiring additional equity or debt finance. The SGR focuses on maximizing profits, through higher sales and retaining them to avoid the dependency on outside sources of finance.

The SGR works under the below-mentioned assumptions.

• The company keeps the single dividend ratio the whole time.
• The company has a constant capital structure.
• It is making great attempts to maximize the sales.
• The business concentrates on higher-margin products.
• The company is making enough efforts to manage inventory, accounts payable, and account receivables.

SGR can provide key information to top executives to help the company plan for the future. It also aids in spotting the inefficiencies in the business operations. Using this, the top executives can make informed decisions, and develop effective strategies.

SGR is an important metric for investors, too. Investors can use SGR to understand the life cycle stage of the company. In the initial stage, companies keep their capital structure intact and rely more on internal reserves. Therefore, their SGR would be higher, and dividend payments would be lower. Once they are all set in the market, they alter their capital structure and start depending on the external sources for finance requirements. The reasons behind this are the intense competition, changes in economic conditions, the need for expensive equipment, etc. Therefore, their SGR would be lower. However, they are more likely to pay higher dividends.

Investors can also evaluate the chances of default of a company by looking at SGR. Too high a growth rate may indicate that the company is highly retaining its earnings and postponing the debt payments.

Though, ideal or appropriate SGR varies depending on the industry. Additionally, businesses cannot maintain a high growth rate in the long term. After a point, when sales reach a saturation point, maximizing the sales becomes the toughest task for businesses. In such scenarios, the profitability of businesses decreases, as they need to shift their earnings towards innovations. This reduced profitability is the biggest risk associated with high SGR.

Formula and Calculation

The Sustainable growth rate can be calculated by multiplying the company’s retention ratio by its return on equity.

• Retention ratio refers to the per cent of net income reinvested in the business, rather than paid out as dividends. The retention ratio can be calculated by this formula.

Retention Ratio = (Net income – Dividends) / Net income Or (1 – dividend payout ratio)

• Return on equity refers to the rate of return generated on the equity shareholders’ investments. Return on equity can be calculated by the following formula.

Return on equity = Net income / Shareholder’s equity

• Therefore, the formula for SGR is as mentioned below.

SGR = Retention ratio * Return on equity

Example

The net income of Company XYZ Ltd. amounts to Rs. 80,000. The shareholder’s equity in the company is Rs. 4,00,000. The company pays out dividends at the rate of 25%. Here is how the SGR of the company would be calculated.

Retention ratio = ( 1 – 0.25) = 0.75 Return on equity = (80,000/4,00,000)= 0.2 Therefore, SGR = 0.75*0.2 = 0.15

• This means Company XYZ Ltd. can sustain a maximum growth rate of 15%, without acquiring additional equity or debt finance.

The difference between the SGR and the PEG Ratio

The PEG ratio is used to assess the growth potential of the business. PEG is an acronym for Price-to-earnings-growth Rate. It can be calculated by dividing the price to earnings (P/E Ratio) ratio of the stock by the earnings per share(EPS) growth rate of the company. For example, the share of ABC Ltd is traded in the market at Rs. 50, EPS is Rs. 10, and the EPS is growing at 4%.

Thus, the P/E ratio would be 50/10 = 5 times Thus, the P/E ratio would be 50/10 = 5 times = 5 / 4 = 1.25

The SGR does not consider the stock price, which is an important element in the PEG Ratio. The main objective of SGR is to assess the growth rate a business can sustain. The PEG ratio indicates the overvaluation or undervaluation of the stock.

Final Words

SGR is an important metric showing the maximum growth rate a company can maintain without altering its existing capital structure. Investors can consider this to evaluate the future potential of the company. Though, SGR solely cannot represent a complete picture. Considering it with the PEG ratio, Internal growth rate, etc. can give investors a more reliable picture.

Moreover, it works under certain assumptions. It does not predict the future accurately if any changes occur in the market over the long term. Though, investors get closer possibilities by analyzing SGR.

Frequently Asked Questions

1. How is a sustainable dividend growth rate defined?

A sustainable growth rate can be defined as the maximum growth rate an organization can attain with existing resources, or without acquiring additional equity or debt finance.

2. Should the sustainable growth rates be high or low?

Though a higher rate is considered the best, the sustainable growth rate should neither be too high nor too low. Too high sustainable growth rate indicates that the company is highly retaining its earnings and may postpone the debt payments. However, a lower sustainable growth rate either means lower sales or lower reinvesting potential.