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Morningstar.com's Interactive Classroom Course 308 SustainableGrowth RateIntroduction In an age when fastgrowing technology companies are trading on promises of big earnings, wouldn't it be great if we could tell whether that projected growth rate is realistic? It may be helpful to consider the sustainablegrowth rate, which shows how much growth a company can potentially generate internally given its level of profitability. How to Calculate the SustainableGrowth Rate To calculate the sustainablegrowth rate for a company, you need to know how profitable the company is as measured by its return on equity (ROE). You also need to know what percentage of a company's earnings per share is paid out in dividends, which is called the dividendpayout ratio. From there, multiply the company's ROE by its plowback ratio, which is equal to 1 minus the dividendpayout ratio. Sustainablegrowth rate = ROE x (1  dividendpayout ratio) You can find all the components needed for the sustainablegrowth rate equation in a stock's Morningstar.com Quicktake Report. Let's go through a hypothetical example. HighTech Corp. is a company with an ROE of 20% that pays out 50% of its earnings as dividends. Based on the above formula, HighTech has a sustainablegrowth rate of 10% (that's 0.20 x Opportunity Doesn't Always Knock While the sustainablegrowth rate is helpful when you're gauging whether a company's growth plan is realistic based on its profits, it is important to note what the sustainablegrowth rate doesn't say. It won't tell you whether a company has the opportunity to grow. If the market for the goods isn't there, it doesn't matter how high a company's sustainablegrowth rate isthe company won't grow. In 1996, for example, athleticshoe maker Reebok RBK didn't post growth anywhere near its sustainablegrowth rate, which was 16% at the time. It was a tough year for athletic shoes, and Reebok's sneakers weren't in fashion. In fact, the company shrank by most measures, including earnings and equity. One good thing about the sustainablegrowth rate, however, is that it really shows how a company's profitability and its growth go hand in hand. What the sustainablegrowth equation says is that, given expansion opportunities, a company's growth is a function of the return it makes on its shareholders' equity and the portion of its earnings that it plows back into that equity. SustainableGrowth Rate and Shareholder Equity Let's go back to HighTech, our hypothetical company with a 20% ROE and a dividend payout of 50%. Say the company has shareholders' equity of $100. In the first year, the firm's earnings were $20 (that's $100 times 20%) and the company plowed back $10 into its equity ($20 x (1  0.50)). Therefore, its new equity was $110 ($100 in beginning equity plus $10 in plowback). That $110 is a 10% increase over the beginning equity. The 10% also represents the company's sustainablegrowth rate. In the following year, the company is expected to earn $22, plow back $11, and end with shareholders' equity of $121, for another $10 increase. In this example, it is evident that in order to grow equity without issuing it, a company has to have a positive ROE. In other words, it has to be profitable. Clearly, companies can grow without being profitable, but it's all in how we define growth. A company such as Amazon.com AMZN is conventionally spoken of as a growth company because its sales have skyrocketed. But it's not profitable, so it's not adding much to its shareholders' equity. On the other hand, the progression of shareholders' equity in HighTech$100 to $110 to $121represents true growth for shareholders. Investors in companies with lots of sales growth but no earnings are implicitly betting that the company will eventually achieve profitability and start showing growth in its equity, too. For "true" growth to happen, a company has to have a certain level of profitability, as the sustainablegrowth equation shows. And it's the growth in the shareholders' equity that, over the long term, will drive the stock price. What the sustainablegrowth rate shows, then, is a company's potential to deliver the kind of growth that will eventually increase the value of its stock. 

Quiz 308 

1  Sustainablegrowth rate indicates:  
a.  Whether a company can sustain a given growth rate based on its present profitability.  
b.  Whether a company would add to its shareholders' equity as it grows.  
c.  Both A and B.  
2  If a company's ROE is 10% and it pays out 30% of its earnings as a dividend, the company's sustainable growth rate is:  
a.  13%.  
b.  10%.  
c.  7%.  
3  What would happen to a company's sustainablegrowth rate if it became more profitable and increased its ROE, but it kept its dividend constant as a percentage of earnings per share?  
a.  The sustainablegrowth rate would increase.  
b.  The sustainablegrowth rate would decrease.  
c.  The sustainablegrowth rate would stay the same.  
4  The sustainablegrowth rate won't tell you:  
a.  The rate at which revenues will grow based on profitability.  
b.  Whether a company can meet its growth expectations.  
c.  Whether a company is increasing shareholders' equity.  
5  If a company is growing, but it is not profitable:  
a.  You cannot calculate a sustainablegrowth rate.  
b.  The company is not adding much to shareholders' equity.  
c.  Both A and B are true. 
To take the quiz and win credits toward Morningstar Rewards go to the quiz page. © Copyright 2006 Morningstar, Inc. All rights reserved. 

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