To grow the business a company has to invest in assets. This investment could be an expansion of its manufacturing facilities, buying of more raw material, new machinery, acquiring any other company, etc. For this investment every company needs funds. These funds can come from company’s existing business operation. If the company can finance its entire investment for future growth by the cash flow from its operations, then it is an excellent thing. But very companies have sufficient amount of free cash flow to fuel its investments for future growth.
Those who don’t have sufficient they have to raise funds from outside, which could be risky sometimes. By knowing about the self-sustainable growth, we can estimate how much a company can grow on its own without the need of external fundraising.
To know the self-sustainable growth of a company we need to know two things.
- How much money is left with the company after paying the dividends
- How much return it is currently generating, that is return on equity
If you know these two things, then you can calculate self-sustainable growth by this simple multiplication
Sustainable growth rate = Retention rate * ROE
If a company pays out 40% of its profit in dividends that means it is retaining 60% of its income and if its ROE is 30% then self-sustainable growth rate(SSGR) will be
SSGR = (60% x 30% )/100 = 18%
That means the company can grow by 18% without external fund raising for growth more than that it will have to raise more funds.
A company that pays 50% dividend and has ROE of 20% will have sustainable growth rate of
SSGR = (50% x 20% )/100 = 10%
Companies with higher self-sustainable growth rate can grow without putting stress on their balance sheet provided other fundamental things are good for the company.
Making investing decision just on numbers is a foolish thing. If you are going to invest just by seeing good SSGR numbers, you can burn your hands. SSGR doesn’t tell anything about whether the company has the opportunity to grow. If the demand for companies product or services is not going to increase, it doesn’t matter how high a company’s sustainable growth rate is–the company won’t grow.
For example in 2015 ITC had ROE of 30% and retention rate of 48%, that means its SSGR is 14.4% but the grew by 2.5% only. Sustainable growth rate only tells that if the expansion opportunities are there, then the company can grow by that sustainable rate without the need of more fund raising.