Introductory Corporate Finance: Financial Planning Sustainable Growth Rate SGR ROE Retention Ratio 1 ROE Retention Ratio Implications for Growth Financing

What This Is

The Sustainable Growth Rate (SGR) is a crucial concept in corporate finance that measures a company's potential growth rate, assuming it retains a portion of its earnings. It's essential for investors and analysts to understand SGR, as it helps determine a company's ability to finance growth through internal means, such as retained earnings, or external means, such as debt or equity issuance. For example, consider Tesla, Inc. (TSLA), with a Return on Equity (ROE) of 20% and a retention ratio of 30%. Using the SGR formula, we can calculate Tesla's sustainable growth rate as follows:

SGR = ROE × Retention Ratio / (1 – ROE × Retention Ratio) = 0.20 × 0.30 / (1 – 0.20 × 0.30) = 0.06 or 6%

Key Formulas & Models

• SGR = ROE × Retention Ratio / (1 – ROE × Retention Ratio) – measures a company's potential growth rate, assuming it retains a portion of its earnings.
  • ROE: Return on Equity, a measure of a company's profitability.
  • Retention Ratio: the proportion of earnings retained by the company.
• ROE = Net Income / Total Shareholders' Equity – measures a company's profitability.
  • Net Income: the company's profit after taxes and expenses.
  • Total Shareholders' Equity: the company's total equity, including common and preferred stock.
• Retention Ratio = (1 – Dividend Payout Ratio) – measures the proportion of earnings retained by the company.
  • Dividend Payout Ratio: the proportion of earnings paid out as dividends.
• WACC = wd × rd(1‑T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt in the capital structure.
  • rd: cost of debt.
  • T: tax rate.
  • wps: weight of preferred stock in the capital structure.
  • rps: cost of preferred stock.
  • we: weight of equity in the capital structure.
  • re: cost of equity.
• DOL = Q(P‑V) / (Q(P‑V)‑F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: quantity sold.
  • P: price per unit.
  • V: variable costs per unit.
  • F: fixed costs.

Step-by-Step Calculation

1. Calculate the Return on Equity (ROE) using the formula: ROE = Net Income / Total Shareholders' Equity.
2. Determine the retention ratio by calculating the dividend payout ratio and subtracting it from 1: Retention Ratio = (1 – Dividend Payout Ratio).
3. Plug the ROE and retention ratio into the SGR formula: SGR = ROE × Retention Ratio / (1 – ROE × Retention Ratio).
4. Use the SGR to determine the company's potential growth rate, assuming it retains a portion of its earnings.
5. Consider the implications of the SGR for growth financing, such as whether the company can finance growth through internal means or needs to issue debt or equity.

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value for WACC, as it reflects the current market price of the company's securities.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs in the WACC calculation, as they represent the costs associated with issuing new securities.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Recognize that sunk costs are non-recoverable costs, while opportunity costs represent the benefits forgone by choosing one option over another.
4. Mistake: Failing to consider the impact of taxes on WACC.
   • Correction: Include the tax rate in the WACC calculation, as it affects the cost of debt.

Exam / CFA Tips

1. Tip: Be aware of the differences between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
2. Tip: Understand the distinction between IRR and NPV ranking.
3. Tip: Recognize the implications of dividend irrelevance vs bird-in-hand.

Quick Practice Problem

A company has an ROE of 15% and a retention ratio of 40%. What is the sustainable growth rate?

Answer: 6% (SGR = 0.15 × 0.40 / (1 – 0.15 × 0.40))

Explanation: The company's sustainable growth rate is 6%, indicating that it can finance growth through internal means.

Last-Minute Cram Sheet

1. SGR = ROE × Retention Ratio / (1 – ROE × Retention Ratio) – measures a company's potential growth rate.
2. ROE = Net Income / Total Shareholders' Equity – measures a company's profitability.
3. Retention Ratio = (1 – Dividend Payout Ratio) – measures the proportion of earnings retained by the company.
4. WACC = wd × rd(1‑T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
5. DOL = Q(P‑V) / (Q(P‑V)‑F) – degree of operating leverage; measures EBIT sensitivity to sales.
6. ⚠️ In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
7. ⚠️ WACC is a weighted average of the costs of debt, preferred stock, and equity.
8. ⚠️ SGR is a measure of a company's potential growth rate, assuming it retains a portion of its earnings.
9. ⚠️ ROE is a measure of a company's profitability.
10. ⚠️ Retention ratio is the proportion of earnings retained by the company.