Sustainable Growth Rate Explained: Formula and Examples

How quickly can a company grow without borrowing more money and without selling more shares? 

The sustainable growth rate (SGR, for short), gives investors that answer, showing how fast a business can grow purely by reinvesting its profits – which makes it especially interesting to dividend investors who desire a growing payout without risking their principal holdings. SGR shows if a business can continue to raise dividends while still having sufficient cash to fund itself. 

By tying together profitability of the underlying business, the reinvestment of those profits, and the payout to shareholders it allows the income oriented investor to make an assessment of a business’s ability to prudently run about by the existence of earnings they do take more likely to sustain dividends and grow going forward.

What you’ll learn

• SGR Defined
• Formula
• Role in Growth
• Dividends vs. Retained Earnings
• Benefits
• Limitations
• Application to Stock Analysis
• SGR vs. Other Growth Models
• Conclusion
• FAQs

Defining the Sustainable Growth Rate

The sustainable growth rate is an indicator of the fastest rate at which a company can grow by reinvesting its own profits. Since the sustainable growth rate relies on, and provides a realistic estimate of, the amount of growth that a company can achieve without incurring debt or issuing additional shares, it is based on actual profitability and retained earnings.

The sustainable growth rate connects three key aspects of a corporation’s performance – its profitability, dividends and retained earnings. Profitability demonstrates how effectively a corporation is generating returns to shareholders (i.e. it converts shareholder capital into revenue). The dividend component indicates the portion of profit returned to investors; retained earnings are available for reinvestment. Collectively, these components demonstrate how management is balancing rewarding shareholders and strengthening the business. The sustainable growth rate reflects this balance, quantifying to what extent a corporation is reinvesting in its business to support the continuation of its growth strategy.

For dividend-focused investors, the sustainable growth rate is an important measure of the ability of a company to maintain or increase dividends without jeopardising its financial health, a high sustainable growth rate indicates that the company has sufficient internal profits to support dividends as well as future growth, while a low sustainable growth rate means that future growth will likely require external financing for dividend increases. Therefore, the sustainable growth rate is an excellent metric for evaluating the relationship between dividend strategy and long-term growth potential.

The Formula for SGR

The SGR can be calculated using the equation: SGR = ROE (Return On Equity) x R (Retention Ratio). This formula combines two key metrics for measuring profitability and allows businesses to project their potential for growth based on earnings as well as their ability to reinvest profits into the business.

The ROE (Return on Equity) measures an organization’s ability to efficiently convert its shareholder’s capital into profit. Higher ROE results in a company generating earnings to provide a basis for continued investment. The retention ratio indicates the portion of earnings retained by the firm after the payment of dividends and is represented by one minus the dividend payout ratio. The retention ratio reveals the total value of profit available for investment into the future.

By applying both of these measurements, one can assess what a company’s forecasted sustained growth is likely to be. For instance, a company may have an extremely high ROE, but if it pays out the majority of its profits through dividends and retains little to reinvest, its sustainable growth prospects will likely be diminished. Conversely, if a company retains a significant percentage of earnings but has a poor ROE, sustaining growth becomes difficult. These tradeoffs are often highlighted in reputable stock advisory services when evaluating long-term dividend sustainability.

Dividend investors must look to both ROE and retained earnings to determine the sustainability of a company’s dividends. A combination of a steady ROE and decent retention that keeps pace with earnings; will bode well for dividend investors seeking reliable payments and growth potential.

Role of Retention Ratio in Growth

The retention ratio determines how much of their own resources companies can grow by; it reflects net earnings retained rather than distributed as dividends. Retained earnings allow a company to fund new projects, strengthen its financial position, or invest in strategic initiatives without relying on outside capital, unlike cases where firms raise large sums from external investors to accelerate expansion. The retention ratio directly affects the capital available for future growth and a company’s ability to expand on a sustainable, self-generated basis.

For dividend investors, the retention ratio shows how management will balance current income versus future ability to earn. High retention ratios indicate that management is focused on reinvesting net earnings back into the business so as to support higher earnings and possibly increasing dividends in the future; this usually results in lower dividends in the near term. Low retention ratios indicate that more net earnings have been distributed back to shareholders, which is beneficial for those investors who are primarily income-oriented, but may potentially limit future opportunities for funding long-term growth.

The appropriate level of the retention ratio varies depending on a company’s age, strategic objectives, and industry circumstances. Mature companies with stable cash flow may operate with low retention ratios because their growth needs are minimal. Conversely, younger or fast-growing companies generally require more than average retention in order to finance their development. For investors, examining the retention ratio in conjunction with profitability and dividend policies provides better insight into whether the company will continue to pay dividends while also growing over time.

Dividends vs. Retained Earnings

The way a company divides its earnings between dividends and retained earnings is crucial to both shareholder wealth and the company’s ability to expand. Dividends offer investors immediate return, which makes them appealing to those who need stable income, especially retirees. However, every dollar paid out is one less dollar available for reinvestment into operations, debt reduction, or strengthening financial reserves, a balance that becomes especially clear when companies announce plans to address large debt loads. Therefore, management must carefully weigh the trade off between providing current income to shareholders and supporting future growth.

The balance between dividends and retained earnings is vital to the long term stability of an investor’s return. Excessive dividend payments to shareholders may limit a company’s ability to take advantage of new opportunities, thereby restricting future earnings potential and slowing the rate of dividend growth. Conversely, retaining a large percentage of earnings allows a company to create significant long term shareholder value, but may not be as attractive to those investors seeking immediate income. Each business, as well as the environment in which it operates, has its own ideal dividend policy. For example, mature companies with limited growth prospects typically pay larger portions of their earnings to shareholders than younger companies with substantial growth opportunities.

Ultimately, the relationship between dividends and retained earnings highlights the need to strike a balance when investing for dividend income. An investor must take into account not only the immediate income produced from dividends, but also how the company plans to continue or increase dividend payments in the future. To build long term wealth with dividends, it is essential to maintain this balance.

Benefits of Using SGR in Dividend Investing

The sustainable growth rate exhibits what a corporation can realize in return on investment while remaining financially viable for dividend investors. While examining only the current dividends, the sustainable growth rate includes profitability and retained earnings in relation to long-term growth. This way, the investor can identify corporations that presently offer dividends, plus how to grow the dividends without relying heavily on foreign capital.

The main benefit of the sustainable growth rate is that it conveys whether or not the company can deliver future dividends sustainably. When the company’s dividend growth is consistent with what internally it can maintain, the company has the capability of delivering dividends at that level into the future. When the growth of dividends is ahead of the sustainable growth rate of the company, the likelihood is that the company will be forced to slow down dividend growth to remain within its sustainable capacity or employ means that decrease shareholder value.

Another advantage of using the sustainable growth rate is that it allows for comparison across many different sectors and levels of development. For example, a utility may have a lower sustainable growth rate but will provide a reliable income stream, while a technology corporation may have stronger reinvestment potential that supports faster dividend growth, especially in an environment where recent AI driven gains have lifted expectations for future expansion. The incorporation of the sustainable growth rate into an investor’s overall analysis of a corporation will provide insight into the area of dividend while forming an investor’s portfolio to receive consistent income with long term equity appreciation.

Limitations of the SGR Metric

While the SGR is an excellent way to gauge a firm’s growth capability; it has several key limitations to consider. One of the biggest criticisms of this metric is its assumption that Return on Equity (ROE) and the Retention Ratio will remain constant over time. In reality, a firm’s income will change based on market demand, competition, and management’s current priorities, causing the sustainable growth rate to often not provide an accurate assessment of a company’s true long-term growth prospects.

Furthermore, this metric does not consider sources of external financing. Many firms utilize a combination of retained earnings, debt, and new equity to fund their growth, as seen recently when companies raised large amounts of capital to support expansion in major markets. This often results in actual growth rates that exceed what the sustainable growth rate suggests. Therefore, the metric may not accurately reflect the growth potential of companies that rely heavily on outside funding, especially those in capital intensive industries. By excluding these external sources, the sustainable growth rate can significantly understate the maximum growth potential of many businesses.

For Dividend Investors, there is also the possibility of incorrectly interpreting this metric. A high sustainable growth rate does not automatically indicate a high likelihood of dividend increases if management is planning to reinvest the majority of profits. On the contrary, a low sustainable growth rate does not preclude that company from being a viable Income Investment if it has a history of providing stable dividend payments. Thus, while the SGR is a valuable tool in determining a company’s growth capabilities, it should be used as part of a comprehensive set of financial metrics and qualitative assessments to ascertain dividend viability and future growth prospects.

Applying SGR to Stock Analysis

By utilizing the SGR, dividend investors can assess a company’s current distribution strength and potential future dividend increases. The SGR incorporates three variables: profitability, retained earnings, and reinvestment capacity, which often come into focus when companies report stronger than expected results or updated profit guidance as seen recently with Pfizer. Thus, investors may identify dividend stocks that are not reliant on external capital to support dividend expansion.

The SGR is often analyzed with other financial metrics to provide context. When compared to the payout ratio, the SGR helps determine if a company is striking a reasonable balance between paying dividends and reinvesting in operations. The SGR also provides insight into whether or not the company’s management is delivering on its expected growth.

The SGR can be systematically applied to evaluate each sector relative to the SGR. In many mature industries, the SGR will tend to be lower than in higher growth sectors, yet these areas still offer steady income generation, which helps explain why some dividend ETFs are beating the S&P 500. A larger percentage of a company’s capital will ultimately support current and future dividends based on the reinvestment capacity of these companies. Therefore, utilizing the SGR in conjunction with an investor’s overall financial objectives allows investment professionals to identify those companies that are likely to be profitable and capable of sustaining dividend growth.

Comparing SGR With Other Growth Models

A company’s ability to grow over an extended period is based on internal funding, therefore the sustainable growth rate reflects how fast a firm can expand without taking on debt or relying on external capital. This differs from the Gordon growth model, which is frequently used to evaluate dividend-paying companies and often appeals to dividend trading strategies because it assumes a fixed long-term growth rate based on forecasts rather than current financial capacity.

In assessing whether a particular growth rate is realistic, the sustainable growth rate would indicate that a company’s future dividend growth rate might be too optimistic if it exceeds the level of support that the company can provide from its own retained earnings. However, if the sustainable growth rate and the Gordon growth model estimate coincide, then the sustainable growth rate has added credibility to the assumption.

Dividend investors should take advantage of the benefits associated with utilizing a sustainable growth rate in conjunction with other tools to assess possible growth potential. The combination of dividend growth projections, using the Gordon growth model, expected future growth rates, or payout ratio projections significantly reduces an investor’s reliance on any one tool, thereby allowing for a more accurate determination if the company will continue to grow at a relatively stable rate of growth or experience future declines in growth, providing a more comprehensive long-term view.

Conclusion

The sustainable growth rate links profitability with retained earnings, indicating the extent of a company’s expansion capabilities using only internally generated resources. This ratio is useful for dividend investors because it communicates the relationship between a firm’s ability to pay dividends and its capacity to reinvest in future growth.

Limitations of the sustainable growth rate include assumptions concerning constant return on equity and retention ratios, lack of access to external financing for business expansion. These assumptions are seldom met, making this a better valuation metric when used in conjunction with other financial ratio analysis instead of as a standalone valuation tool.

The sustainable growth rate provides a good indication of a company’s growth and dividend capabilities when evaluated alongside other valuation tools such as payout ratio analysis, cash flow history, and balance sheet evaluation, which often plays a role in market discussions about how central financial positions influence long term stability. By utilizing these different types of ratio analysis along with the sustainable growth rate, investors can find companies that have the potential for continued, responsible growth and the ability to pay healthy dividends.

About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.