Sustainable growth is the growth a company can grow at given its profitability and reinvestment decisions without taking on additional debt. The equation for sustainable growth = Retention ratio* Return on Equity. And since the retention ratio is equal to 1- Payout ratio, sustainable growth is also = (1- Payout ratio) * Return on Equity. We understand what the sustainable growth rate is and its formula. Can I use the sustainable growth rate as my company’s growth rate in the DCF valuation model?
No, a company’s growth rate depends on many factors. These factors include the market size, competition, company’s strategy and execution, etc. The sustainable growth rate shows you the potential growth rate given a company’s profitability and reinvestment decisions. A company may grow at a lower rate if the market conditions are unfavorable. And a company may grow at a higher rate if it encounters favorable conditions, uses additional funding, expands into different markets, etc.
Note: A company can grow at a sustainable growth rate. But it need not do so. The sustainable growth rate is only used to check the model assumptions.