What is the sustainable growth rate and how is it connected to ROE and retention?

The sustainable growth rate is the maximum rate at which a company can grow its earnings and dividends without issuing new equity or changing its capital structure. It's a bridge between financial analysis and equity valuation.

The Formula:

g = ROE x b

Where:

• g = Sustainable growth rate
• ROE = Return on equity
• b = Retention ratio = 1 - Payout ratio = 1 - (Dividends/Net Income)

Intuition:

Every year, the company earns a return on equity (ROE). It pays out some as dividends and retains the rest. The retained earnings increase the equity base, which can support more assets and generate more earnings — that's the growth.

Example:

Arcadia Technologies has:

• ROE = 18%
• Payout ratio = 40% (so retention ratio = 60%)

SGR = 18% x 0.60 = 10.8%

Arcadia can grow earnings and dividends at 10.8% per year without raising new equity.

Connection to the Gordon Growth Model:

Recall: V₀ = D₁ / (r - g)

The SGR gives you an estimate of g! If Arcadia's required return is 13%:

D₁ = D₀ x (1 + g) = $2.00 x 1.108 = $2.216

V₀ = $2.216 / (0.13 - 0.108) = $2.216 / 0.022 = $100.73

DuPont connection:

Since ROE = Margin x Turnover x Leverage:

g = (Margin x Turnover x Leverage) x Retention Rate

This shows that growth comes from four levers:

Limitations:

• Assumes constant ROE, payout ratio, and capital structure
• Ignores that ROE may decline as the company reinvests in lower-return projects
• Doesn't account for share buybacks or new equity issuance
• Companies growing faster than SGR are either issuing equity, taking on more debt, or temporarily achieving unsustainably high ROE

Exam tip: If a question provides ROE and dividend payout ratio, compute SGR immediately — it's likely needed for the GGM valuation that follows.

Practice growth rate calculations in our CFA Level I question bank.