Sustainable Growth Rate

A company's maximum possible growth rate without needing external equity and debt financing

The sustainable growth rate (SGR) is a company's maximum possible growth rate without needing external equity and debt financing.

SGR is the growth rate that is achieved through internal accruals alone. A high sustainable growth rate is a positive factor for a company.

A high SGR states that the company is profitable and efficient enough to fund everything through internal accruals.

Internal accruals are the company's leftover profits after dividend payments. Also called the plow back ratio, which shows the company's retained earnings level.

Formula:

Formula

ROE is used because retained earnings are accounted for in the equity account. 

Adjustments can be made to dividend payout ratios depending on the company. For e.g. if a company has payout cycles, the ratio can be normalized and then used to get a more consistent growth rate.

The SGR is the rate at which the company is expected to grow in the future. A higher SGR suggests that the company is efficiently using retained earnings to generate a high return on its equity.

The SGR is a very useful tool for the investors, creditors & rating agencies, and the corporate finance team of the company.

Understanding the Sustainable Growth Rate

It is the maximum limit a company can grow without needing any external financing of equity or debt.

The SGR of a company tells a lot about the company. For example:

1. Its position in the corporate cycle 

2. Its financing options 

3. Payout strategy for the future.

It dictates the financial health of the company. Firms with high sustainable growth rates won't need to fill their balance sheets with debt or dilute their equity.

A high-quality, high-growth business usually has a high SGR. The reason for that is the firm can reinvest the capital at a higher rate which further increases the ROE.

Dividend payout is also equally important. If the company is paying a large chunk of its net profits as its dividend it will drive down the overall sustainable growth rate of the company.

For example, if a business is generating a 50% return on its equity capital which is very impressive but is paying out 90% of its profits, then the SGR comes at 5%.

The above example suggests a couple of outcomes, either the company is paying out more than its capacity, or a 5% growth rate is suitable for the company given its overall growth, maturity, market position, and capital structure.

This can also be used as a relative metric.

A high SGR also tells us that the company is investing a lot into R&D and Capex into projects with high net present values (NPVs).

The sustainable growth rate is used to assess:

1. Company's corporate life-cycle

2. Capital structure & dividend payout

3. Credit rating

Corporate Life Cycle

It can be used to visualize the stage of the firm in its corporate life cycle.

Graph interpretation

Younger companies usually have high requirements for external financing especially if they are in a competitive industry or are aiming at disruptions.

The reason they need external financing is that they have high operating expenses which leaves the firm with very little to no profits to reinvest.

So for Capex, investments, expansion, and at times even to pay for operating expenses these firms need to raise capital. 

As there are limited to no profits, their return on equity is either negative or not very high leaving sustainable growth rates on the lower end.

A negative or low SGR means that the company cannot function very long without external capital.

On the other hand, mature companies have higher sustainable growth rates as they produce high levels of net profits and can finance their expansion through internal acquisitions.

High net income means high ROE which will result in high SGRs.

As the SGR starts to grow it can be assumed that the company is also growing through its life cycle.

Capital Structure

It is one of the key metrics that actually dictates the capital structure of the firm.

Low sustainable growth rates make it really difficult for a company to function for a long time without the infusion of outside capital.

The external capital can be equity or debt. Equity is more expensive to raise but will not impact the balance sheet, debt is cheaper and has tax benefits but can deteriorate the balance sheet and if not handled properly can potentially destroy the firm.

Usually, if the SGR is very low or negative, equity funding is preferred by the management as the operational expenses are so high that adding another line item will disturb the operational spending.

As the SGR starts to rise, the company can look at debt as a funding alternative as they will have enough EBIT to service that debt. Eventually, the need for external financing will be very limited.

Just because it has a high rate it does not mean that the company will not take any external financing or debt. 

The capital structure of the company is a decision of the corporate finance team, the management, and the industry standards and requirements. SGR only serves as a benchmark.

Credit Rating

Rating agencies can use SGR to rate the debt that the company has on its books.

The assessment made is very straightforward if the company can sustain high growth through internal accruals, it means that they have enough cash to service the debt and thus can be assigned a good rating.

The opposite will be true if the firm has a lower SGR, it will be advised to avoid debt and the rating won't be of the highest quality.

The company's ability to service the debt is the most important factor in rating debt and SGR does hint at the debt-serviceability of a firm.

Calculating Sustainable Growth Rate

To get a better understanding of the SGR we'll take a look at a few different businesses that have different levels of debt and operating leverages and are in different stages of their corporate life cycle.

Exhibit 1: The Sherwin-Williams Company (SHW)

Sherwin-Williams is the largest paints and coatings manufacturer in the world. The overall industry has a stable growth rate and SHW specifically grows through M&A.

Annual Report

Financial statements The Sherwin-Williams Company

Return on Equity = Net Income / Shareholder's Equity

(figures in million $)20212020
Net Income18642030
Shareholder's Equity24373610
Return on Equity76.48%56.23%

 

The diluted EPS for 2021 stands at $6.98, and SHW has paid dividends of $2.20 per share.

The payout ratio comes at 31.5%.

The retention ratio comes to 68.5%

SGR = Retention Rate * ROE

SGR = 68.50% * 76.48%

SGR = 52.38%

This means The Sherwin-Williams company can grow at 52% without any need of external financing.

This is possible because Sherwin-Williams is a mature business with competitive advantages that allow them to generate a consistently high ROE.

Exhibit 2: Block Inc. (SQ)

Block, previously known as Square, is a financial services company selling hardware systems and software for payment processing and analysis and a few other related businesses.

Annual Report

 Block Inc.Liabilities

Return on Equity = Net Income / Shareholder's Equity

(figures in thousand $)20212020
Net Income166284213105
Shareholder's Equity33135892681569
Return on Equity5.00%8.00%

 

SQ has an ROE of 5% for 2021.

Block Inc, pays no dividends to its shareholders so the retention rate is 100%.

This means SGR = ROE = 5%.

An SGR of 5% states that SQ can only grow at 5% without any need for external funding. This low growth rate results from high operating expenses and lower returns on the capital being invested into the business.

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Researched and authored by Aditya Salunke I LinkedIn

Reviewed and Edited by Abhijeet Avhale | LinkedIn

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