Frequently, analysts are interested whether a certain growth rate is sustainable in the long run, that is, whether a company can grow at this rate indefinitely in the future without changing the capital structure. Such rate may be used as a proxy for the mature growth rate for a company. Sustainable growth rate can be estimated using the following formula:

g = b x ROE

where b is a retention rate, and ROE is the return on equity.

Earnings and dividends grow at the rate g indefinitely, provided that two assumptions hold:

• If a company issues new debt at the same rate g to maintain constant capital structure (remember that a part of earnings is retained every year, adding to equity);
• ROE and dividend payout rate are constant.

We have already discussed the DuPont system for calculation of ROE previously. The simple DuPont formula decomposes ROE into three ratios, characterizing company profitability, operating efficiency, and financial structure:

Return on Equity = Profit Margin x Total Asset Turnover x Financial Leverage
= Net Income / Sales x Sales / Total Assets x Total Assets / Common Equity

If we multiply both sides by retention ratio, we can analyze the sustainable growth rate based on the ratio analysis:

Sustainable Growth Rate = (Net Income - Dividends) / Net Income x Net Income / Sales x Sales / Total Assets x Total Assets / Common Equity.

Earnings retention ratio and equity multiplier describe the financing decisions of a company. Net profit margin and total assets turnover characterize the profitability and operating efficiency of a company (note that the product of the two ratios is return on assets, ROA).