Sustainable Growth Rate - Meaning, Formula, Calculation & Interpretations

Summary

In this video, Dheeraj Vadhi explains the concept of Sustainable Growth Rate (SGR) as part of a series on ratio analysis. SGR reflects how much a company can grow using its internal resources without relying on external financing. The video covers the formula for calculating SGR, focusing on Return on Equity (ROE) and Retention Ratio. Through the Colgate case study, the video demonstrates how these ratios help analyze a company's growth potential. Despite Colgate's high SGR due to its buyback policy, the focus remains on understanding sustainable growth in mature companies.

Takeaways

• 😀 Sustainable growth rate (SGR) represents the rate at which a company can grow without requiring external capital (debt or equity).
• 😀 The SGR is especially useful when forecasting, projecting, and valuing companies.
• 😀 Startups typically grow at a high pace but rely on external capital, whereas mature companies can sustain growth using internal profits without needing additional equity or debt.
• 😀 The SGR formula is: SGR = Retention Ratio × Return on Equity (ROE).
• 😀 Return on Equity (ROE) is calculated as Net Income ÷ Shareholders' Equity, showing how much income a company generates per dollar of equity.
• 😀 The Retention Ratio is the percentage of net income retained in the company, calculated as 1 minus the Dividend Payout Ratio.
• 😀 The Dividend Payout Ratio is the percentage of net income paid out as dividends to shareholders.
• 😀 Mature companies typically balance between retaining earnings for growth and distributing dividends to shareholders.
• 😀 For Colgate's SGR, historical data of net income and dividends were used to calculate the Dividend Payout Ratio, and from that, the Retention Ratio was derived.
• 😀 Colgate's relatively high ROE and low shareholder equity (due to its buyback policy) resulted in an unusually high SGR, making interpretation of these numbers challenging.
• 😀 The video emphasizes the importance of understanding the historical Dividend Payout Ratio and retention practices to predict future growth sustainability.

Q & A

What does Sustainable Growth Rate (SGR) signify in a company?

Sustainable Growth Rate (SGR) signifies how much a company can grow in the future without relying on external capital, such as debt or equity, and maintaining financial stability.

What phase of a company's lifecycle does the concept of SGR apply to?

The concept of SGR mainly applies to the mature phase of a company's lifecycle, where the company is profitable and does not require external debt or equity for growth.

What is the formula for calculating SGR?

The formula for calculating Sustainable Growth Rate (SGR) is: SGR = Retention Ratio × Return on Equity (ROE).

What is the significance of Return on Equity (ROE) in the SGR calculation?

Return on Equity (ROE) measures how much profit a company generates with its shareholders' equity. In the SGR formula, it helps to determine how efficiently the company is using its equity to generate growth.

How do you calculate the Retention Ratio for SGR?

The Retention Ratio is calculated by subtracting the Dividend Payout Ratio from 1. The Dividend Payout Ratio is the proportion of net income paid out as dividends, so the Retention Ratio indicates how much of the net income is retained for reinvestment.

What is the Dividend Payout Ratio?

The Dividend Payout Ratio is the proportion of a company's net income that is distributed to shareholders in the form of dividends. It is calculated by dividing the total dividends paid by the net income.

Why is the retention of earnings important for calculating SGR?

Retention of earnings is important for calculating SGR because it reflects the amount of profits reinvested into the company, which helps fuel future growth. A higher retention ratio indicates more resources are available for expansion without external capital.

What impact can stock buybacks have on ROE and SGR?

Stock buybacks can reduce shareholders' equity, which inflates ROE since ROE is calculated as net income divided by shareholders' equity. This can distort the SGR, making it appear higher than it is, as the company's equity base is artificially reduced.

What role does the maturity phase play in the SGR concept?

In the maturity phase, companies typically have stable operations and profitability. They no longer rely on high levels of debt or equity funding, and the SGR helps assess how much they can grow using internally generated funds without external capital.

Why is Colgate's SGR calculation potentially skewed in the tutorial?

Colgate's SGR calculation is skewed because of the company's stock buyback policy, which reduces shareholders' equity. This results in an inflated ROE, and consequently, an unrealistic SGR calculation, making it difficult to interpret the true sustainable growth rate.