Sustainable Growth Rate

Updated: Jul 12, 2021

Sustainable Growth Rate = Return on Equity * Plowback Ratio

The sustainable growth rate indicates the rate at which a company can grow earnings consistently over time by re-investing earnings. Sustainable growth rate (SGR) illustrates the relationship between retained earnings, return on equity, and the speed at which a company can grow earnings.

One of the most important ideas that SGR illustrates is the impact of dividends. A business has two choices as to what to do with earnings. Earnings can either be retained or paid out to shareholders as dividends. When earnings are retained (kept in the business) it is essentially an investment in the companies operations. When earnings are paid out as dividends the investor has the option to invest those dividends how they like.

We can quantify the amount of earnings retained in the business using the plowback ratio. The plowback ratio measures the percentage of earnings that are "plowed back" into the business. Conversely, 1-plowback ratio is the payout ratio, the percentage of earnings paid to shareholders as dividends.

If a business earns $100 dollars and pays 30$ to shareholders as dividends then the plowback ratio is .7 and the payout ratio is .3.

Retained earnings is an equity line item on the balance sheet. If a business earns a $100 profit and retains all of those earnings then all else being equal the equity on the balance sheet will rise by $100. If that same company chooses to pay a $30 dividend retained earnings will fall by $30 dollars and equity will also fall by $30.

This happens by:

1) Debiting revenue and crediting income summary

2) Debiting income summary and crediting expenses

3) Debiting or creditng income summary to retained earnings depending on whether the company was profitable.

4) If the company pays a dividend debit retained earnings and credit dividends payable

Let's assume that the company has earned a return on equity around 15% each year for the past ten years (Equity = Assets -Liabilities). If we retained all $100 of earnings we would have increased our equity by $100 dollars and would expect to make $100 * 15% = $15 on this additional equity next year. However, if the company only retained half of their earning we would expect equity to increase by $50 and the company to earn an additional $50*.15=$7.50 next year.

If we replace the dollar amount of earnings retained above with the plowback ratio we are able to calculate the sustainable growth rate. For example, if the plowback ratio was 50% the sustainable growth rate would be .5*1.5=.075 or 7.5%.

Some people may conclude that this implies dividends are bad. This is not necessarily the case. For example, suppose you own a business that earns a low return on equity, say 5%, if you retained all earnings the SGR would only be 5%, on the other hand, if the company paid out all earnings as dividends investors could potentially invest that money at a greater than 5% return elsewhere. Therefore, maximizing shareholder wealth may be achieved by paying dividends or retaining earnings depending on the investment alternatives.