Course 308: Sustainable-Growth Rate
Sustainable-Growth Rate and Shareholder Equity
 In this course 1 Introduction 2 How to Calculate the Sustainable-Growth Rate 3 Opportunity Doesn't Always Knock 4 Sustainable-Growth 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 sustainable-growth 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 \$121--represents 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 sustainable-growth equation shows. And it's the growth in the shareholders' equity that, over the long term, will drive the stock price. What the sustainable-growth rate shows, then, is a company's potential to deliver the kind of growth that will eventually increase the value of its stock.

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