What is the Sustainable Growth Rate (SGR)

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  • 14 Dec 2023
What is the Sustainable Growth Rate (SGR)

Key Highlights

  • Sustainable growth rate (SGR) is the growth rate a company can achieve without taking additional debt.
  • A company can compete, only if its growth rate is strong enough.
  • However, a company may face potential issues if its growth rate is very high. It is essential to consider the potential drawbacks of such rapid expansion.
  • Combining debt and equity capital can build a balanced approach for long-term growth.

Definition of Sustainable Growth Rate

A sustainable growth rate (SGR) is the growth rate that a business can achieve without taking more debt or equity capital. So, it denotes the pace at which a company may expand by using its existing assets. The term "sustainable growth rate" describes a firm's life cycle. It provides a clear view of the key areas for achieving the desired growth.

SGR works on the basis of certain presumptions. They include the following.

  • The company never modifies its single dividend ratio.
  • The capital structure of the firm remains steady.
  • It is working hard to increase sales.
  • The company focuses on products with better profit margins.
  • The business is working hard enough to manage its inventory, accounts payable, and accounts receivable.

##Calculating the Sustainable Growth Rate##

Let’s now look at the Sustainable Growth Rate (SGR) formula. However, to understand the SGR formula you need to first know about a few terms. They are as follows.

  • Dividend payout ratio: The percentage of earnings that shareholders receive as dividends per share is the dividend payout ratio. Its formula is dividends per share/earnings per share (EPS).

  • Retention rate (1 - dividend payout ratio): This is the portion of earnings that a business still needs to distribute dividends. In simpler terms, it is the income that the company keeps for itself.

  • ROE: Return on Equity (ROE) measures how much an investor earns based on the company's profits. Its formula is Net income / Total shareholder equity.

The company's financial statement often includes ROE and dividend ratios.

SGR Formula:

So, the formula of SGR is;

Sustainable Growth Rate = Retention Ratio * Return on Equity

Example:

The net income of Company Alpha is Rs. 50,000. Shareholder equity is Rs. 2,00,000, and the dividend payout rate is 15%. Here is how to calculate the company's SGR.

Retention ratio = ( 1 - 0.15) = 0.85 Return on equity = (50,000/2,00,000)= 0.25 So, the SGR = 0.85*0.25 = 0.21

Hence, Company Alpha can achieve a maximum growth rate of 21% without any additional equity or debt financing.

Benefits of SGR

The sustainable growth rate can help a business with the following things.

  1. Long-term growth planning and cash flow projections
  2. Borrowing additional funds
  3. Grow by issuing equity and compensating the equity investors
  4. Audit its expenditure and profit
  5. Make strategies for better efficiency
  6. Manage day-to-day operations like early bill payment
  7. Ensure financial efficiency and manage receivable and payable accounts
  8. Plan the financial future by setting goals that won't put them in financial stress
  9. Help determine the amount of capital for steady growth.

The Drawback of using SGR

Using the SGR to calculate the growth rate is helpful. Yet, it is still not perfect.

  1. The averages of a particular sector are the basis for the sustainable growth rate formula. Thus, it might only be valid for some businesses in a specific industry.

  2. Three different elements are the basis of the SGR formula. They are retention ratio, dividend payout, and ROE. However, they may or may not correctly reflect the current state of a company's affairs.
    Difference Between SGR and PEG Ratio

A measure of a company's potential for growth is the price-to-earnings-growth ratio (PEG) ratio. Here are the key differences between the SGR and PEG

Feature SGR PEG
DefinitionA measure of the company's growth in relation to its existing capital structure.A measure of the company's growth in relation to its stock price.
PurposeTo determine whether a company's stock is overvalued or undervalued.To determine whether a stock is undervalued or overvalued.
Formula(Sales growth + Operating profit margin growth + Equity growth) / 100(Price-to-earnings ratio) / (Earnings per share growth rate)
InterpretationA higher SGR indicates faster growth. Still, it does not necessarily mean the stock is overvalued or undervalued.A PEG ratio of less than 1 indicates that the stock may be undervalued, while a PEG ratio of more than 1 indicates that the stock may be overvalued.
LimitationsThe SGR does not take into account the company's debt levels or the quality of its earnings.The PEG ratio assumes that the company's earnings per share growth rate will remain constant. This may not be the case always.

Conclusion

One should consider the sustainable growth rate (SGR) while investing in a stock. The SGR represents the expected future growth rate of a company without taking debt. It indicates a company's capacity to expand over time without negative effects on its stakeholders, customers, and employees. A higher SGR indicates that the business is using its earnings to provide high returns on equity. Thus, SGR is a beneficial tool for investors, creditors, rating agencies, and the finance team.

FAQs on Sustainable Growth Rate

The sustainable growth rate (SGR) is the growth rate a company can grow without external funding. On the other hand, the terminal growth rate is the projected growth rate used to estimate free cash flows.

A high SGR indicates that the business can fully finance its rapid expansion using its revenue. It does not need external investments. A low SGR indicates that the company will need external funding to expand its operations.

The dividend payout ratio is the proportion of earnings distributed as dividends. It shows a company's ability to maintain its growth through retained earnings in the long term.

Yes, companies can increase their SGR by improving the Return on Equity (ROE), and profits. They also have to retain a higher portion of their earnings for reinvestment.

Yes, companies can exceed their sustainable growth rate by using external funds. They may issue fresh equity or take on more debt.

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