The Sustainable Growth Rate
Although companies can grow at extremely rapid rates for some time, such growth cannot typically be sustained. Valuation methods such as the Gordon growth model and other discounted cash flow models require a growth estimate than can be sustained for many years - often it is assumed to be a perpetual growth rate.
If a company can earn a 15% return on equity (ROE), it can grow 15% simply be reinvesting earnings in new opportunities. In order to grow faster, the company would have to invest more capital than its own earnings by using debt or equity financing. If the company pays part of its earnings as dividends, it would have a lower potential growth rate without issuing new debt or equity.
Thus, the sustainable growth rate can be estimated as g = b x ROE, where b is the percentage of earnings retained (not paid out as dividends.)
For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Investment Returns, Valuation See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
[...] tons of it. The consensus 5-year growth rate is 30%, but based on its return on equity MEMC has a sustainable growth rate of nearly 55% (which happens to be its growth rate over the past five [...]
January 14th, 2008 at 6:11 am
[...] marks a modest slowdown from the 13% generated over the last five years. It is also well below the sustainable growth rate of 29%, which is further evidence of excess cash flow that can be used for more share [...]
February 7th, 2008 at 11:42 am