When building an investment portfolio, investors and analysts often rely on financial analysis to determine which securities are worth including in their portfolios. A core part of this process is equity analysis—evaluating whether a stock’s market price aligns with its intrinsic value.

To make these assessments, professionals use various financial ratios. Some of the most commonly used include earnings per share (EPS), price-to-earnings (P/E) ratio, and dividend yield. These provide valuable insight, but they only scratch the surface. To gain a better understanding of a firm’s value and potential, we need to explore additional tools—one of which is the sustainable growth rate (SGR).

Sustainable Growth Rate: A Deeper Indicator

The sustainable growth rate (SGR) indicates how quickly a company can grow without needing to raise external equity capital. It’s a crucial measure for long-term investors who prioritize companies capable of sustaining themselves through expansion. In equity analysis, the SGR provides insight into whether a firm’s internal resources can support its projected growth.

At the heart of the SGR is the relationship between retained earnings and net income. Once a firm earns a profit, it must decide how much to distribute as dividends and how much to reinvest in the business. The portion that is retained supports the company’s future growth. Therefore, a higher level of retained earnings often signals greater growth potential—a key consideration in equity analysis.

Calculating the Retention Rate

To determine SGR, we must first understand the retention rate (RR), which reflects the proportion of net income that a company keeps instead of distributing to shareholders. The formula is:

Retention Rate (RR) = (Net Income − Dividends) / Net Income

Alternatively, since the dividend payout ratio equals Dividends ÷ Net Income, we can express:

RR = 1 − Dividend Payout Ratio

This relationship illustrates the complementary nature of the two ratios—together, they always sum to 1.

Applying the Concept: A Case Comparison

Let’s assume Company A and Company B both report a return on equity (ROE) of 10%. Company A, however, has a dividend payout ratio of 30%, while Company B pays out 50%:

  • Company A’s retention rate = 1 − 0.30 = 70%
  • Company B’s retention rate = 1 − 0.50 = 50%

Using the formula for SGR (Sustainable Growth Rate = Retention Rate × ROE), we calculate:

  • Company A: 70% × 10% = 7%
  • Company B: 50% × 10% = 5%

Despite similar profitability, Company A demonstrates a higher potential for growth simply because it reinvests a greater portion of its earnings.

Real-World Application: SaleSmart’s Ratios

To illustrate the concept, let’s consider SaleSmart—a hypothetical company used for educational purposes:

  • Net Income: $8,898 million
  • Retention Rate = 50%
  • Dividend Payout Ratio = 50%

This balanced approach indicates that the firm distributes half of its earnings as dividends. Applying the sustainable growth rate formula, the figures suggest consistency over time while also pointing to a moderately aggressive dividend policy that could limit future growth potential:

  • Current Year SGR = 50% × 14.43% = 7.215%
  • Previous Year SGR = 53% × 13.14% = 6.9642%

Assessing Risk: The Role of Variation Ratios

While SGR is important, it doesn’t exist in isolation. To honestly evaluate a firm’s growth potential, analysts must assess business risk. One key metric used here is the coefficient of variation (CV), calculated as:

CV = Standard Deviation / Mean

By applying this to such metrics as operating income, net income, or revenue, analysts can estimate how volatile a company’s performance is. A high CV indicates greater risk and less stable growth, while a low CV signals more consistent performance. Therefore, a company with a high SGR and low CV is generally a better candidate for long-term investment.

Equity Analysis: Growth, Risk, Value

Equity analysis blends valuation with risk assessment. Beyond just comparing price multiples and earnings, understanding ratios like the sustainable growth fate and coefficient of variation helps investors identify firms that not only grow but grow sustainably and reliably.

These fundamentals form the backbone of equity valuation. If you’re interested in deepening your understanding, consider enrolling in our Introduction to Equity Securities or Fundamentals of Equity Valuation courses to explore these concepts further and apply them with confidence in real-world scenarios.

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