Sustainable Growth Rate
So I am having trouble believing that the sustainable growth rate (sustainable sales growth rate) is ROE*(1-dividend payout ratio).
Let's assume a fixed leverage ratio and no new equity financing. Then to calculate the sustainable growth rate: First, in order to increase sales growth, you need to increase assets. Thus, in order for the left side of the accounting equation (A=L+SE) to increase, we must increase the liabilities and shareholder equity on the right. Since we assume a fixed debt ratio, increases in SE will govern increases in L. With no new equity, the growth in SE will thus be from retained earnings.
Now this is the part I don't understand. We say sustainable growth is equal to ROE(1-dividend payout ratio) because growth in equity governs the growth in L and thus the growth in assets. But since L is also growing when equity grows, shouldn't the growth in assets be larger than just the ROE(1-dividend payout ratio)? We are not considering the fact that L is growing at the same rate, so to take into account both L and SE growing, shouldn't sustainable growth and thus growth of the A be twice ROE*(1-dividend payout ratio)?
Are we just assuming the liabilities doesn't increase? If that's the case, how do we keep leverage ratio constant? Do we keep the leverage ratio constant for the FOLLOWING year?
Any help is appreciated.
If you are questioning why everything grows proportionally: From my understanding you take Free Cash Flow and discount it by k minus your sustainable growth rate of g.
So FCF/(k-g) = Value of Firm
Because FCF takes into account everything that happens to the firm from revenues on down, you are assuming everything will grow at a proportionate rate; equity and liabilities included.
If you are questioning why we use ROE instead of ROA: Interest is basically treated as an expense since it is taken out before ROE is calculated, and therefore is not treated with the same growth rate. ROE represents the actual return you are receiving, while the total assets just represent what you are using to create that return.
Equity Value = Firm Value - Debt Owed
As for the leverage ratio, that should decrease if all of earnings are plowed back and remain constant (growth rate of zero) if everything is paid out as a dividend.
Does that answer your question?
Does this answer your question?
SGR is antiquated at best: "The maximum growth rate that a firm can sustain without having to increase financial leverage." It has little meaning. A pure net income & book equity anchored logic is just incongruent with reality. A firm could be taking massive non-cash charges yet receiving massive proceeds from divestitures and cash flow benefits from NWC release, book equity could be all messed up from previous year's unfunded pension liabilities growing as a result of exogenous factors -- the former could make payout ratios > 100% ("necessitating" a negative SGR) and the latter highly inflate ROE.
Earnings and book equity (the two main players in SGR) are two of the many variables into capital structure decisions, but not comprehensive enough. I know that this is an academic proxy and yes, difficult to apply. But I don't think developing industry-centric SGR methodologies based on the actual cash inflows and outflows would be that much of an incremental intellectual challenge...
This is the massive problem with academia. Dividends are not paid out from EARNINGS they are paid from FCF and/or existing unrestricted cash balances. The only reason why "payout" ratios exist is to simplify things for retail investors.I realize dividends are not paid out of earnings but the ratios are used for a reason; they simplify the situation. Aside from that inconsequential point that you felt obligated to make about the 'flaws' in my academia, are there are gaping holes in my logic that actually merit correction? If I made a mistake please correct me, but my explanation was obviously oversimplified and not meant to include every footnote I could think of.
ROE = (Net Income/Sales)(Sales/Assets)(Assets/Equity)
The leverage ratio is captured in assets/equity
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