A wise investor leaves no stone unturned in pegging a company’s potential before he/she decides to invest in it. Luckily, there are several metrics at a person’s disposal that offers this insight, like the PEG ratio and sustainable growth rate. Although no ratio spells out in certain terms whether a company has the legs to turn profitable for the investor, in the long run, analysing them can bring an investor as close to that certainty as is possible.

The sustainable growth rate is a vital indicator of an organisation’s competency in maintaining its short-term assets and working capital. In turn, this provides an understanding of the viability of its growth with its current resources.

What is the Sustainable Growth Rate?

It’s the growth rate that a company can afford without leveraging debt or raising equity capital. In other words, it refers to the rate at which an organisation can grow by maximising utilisation of its current resources.

The sustainable growth ratio works under the following assumptions –

  • The organisation in question maintains a single dividend ratio throughout.
  • It has a fixed capital structure.
  • Inventory management is optimal.
  • The company is striving to maximise sales.
  • There’s a process in place that facilitates repeat sales.
  • The enterprise focuses on high-margin products.

A company meeting these criteria can achieve and maintain a high sustainable growth rate, which is always a positive indicator of its operational competency.

How to Calculate Sustainable Growth Rate?

To calculate SGR, one must first compute the retention ratio and return on equity of a company.

Retention ratio refers to the portion of profit a company retains after it has distributed dividends. Thus, it’s represented as –

I. Dividend payout ratio.

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Return on equity denotes the relationship between a company’s net profit and its number of outstanding shares. It’s reckoned as –

II. Net profit/Total shareholder’s equity

The sustainable growth rate formula is the product of these two metrics, and can be expressed as:

Retention ratio (i) x Return on Equity (ii)

An example using this formula can better elucidate the concept of sustainable growth rate-

Company A has paid out dividend at the rate of 30% and clocked a return on equity of 20% in 2019. Hence, its sustainable growth rate = 0.2 x (1 – 0.3) or 0.14.

This signifies that Company A can attain a maximum growth rate of 14% without resorting to external financing.

What is the Significance of Sustainable Growth Rate?

A company’s SGR is indicative of several factors, which include –

  • Stage of the life cycle

The calculation of the sustainable growth rate takes into account the dividend payout ratio of a company. It helps in understanding the life cycle stage at which the organisation currently is.

Companies with low SGR are usually mature companies that can afford to pay a hefty portion of their net income as dividends. Conversely, a high SGR signals an enterprise in its growing stages, where it cannot pay out dividends at all or the percentage is comparatively lower.

It’s recommended to make this interpretation in the context of the industry to which a company belongs since conclusions can widely vary based on that.

  • Management of debtors

Usually, prolonged cash cycles can limit an enterprise’s potential to grow. Naturally, this reflects in its sustainable growth rate. A low SGR, thus, can signify that the company in question is not managing its accounts receivables efficiently.

On the other hand, a high sustainable growth rate denotes efficient management of accounts receivables, minimising the need for external financing.

  • Helps streamline financial objectives

A sustainable growth rate is an excellent tool that organisations can use to reflect on their approach in the context of their financial potential and objectives.

For instance, suppose a company is clocking a lower growth rate in comparison to its SGR. In that case, one may infer inefficiency in its processes that are hindering maximum utilisation of resources.

The management can subsequently undertake measures to identify and straighten these discrepancies to unlock the company’s full potential.

Similarly, suppose per a company’s financial objective, it ought to achieve a growth rate of 15%; but, its SGR is only 12%. Thus, it might need to plough back dividend payments to realise that mark.

Regardless of its various interpretations, however, one should note that a company can seldom maintain a high SGR over an extended period. That’s because the high-margin products that are crucial to a strong SGR often reach their saturation point after a period.

An enterprise will have to invest in new products then, which might not boast of such high margins. That will inevitably compromise on profitability, in turn, bringing down the sustainable growth rate.

What is the Difference between SGR and PEG?

The price-to-earnings-growth or PEG ratio signals the value of a company’s stocks, coupled with the growth of its earnings. Here’s how it differs from SGR –

Sustainable growth ratio Profit-to-earnings-growth ratio
It’s used to determine a company’s growth in relation to its existing capital structure. It’s utilised to signal an organisation’s growth in earnings in relation to its stock price.
SGR does not reveal whether a company’s stock is overvalued or undervalued. Value investors often utilise a PEG ratio to determine whether a stock is undervalued or overvalued.

It’s essential not to single out one metric, like the SGR, to evaluate a company. Investors must utilise additional indicators and ratios to peg a company’s potential and worth as an investment option better.