CFA Level IEquity InvestmentsMedium
A company has a return on equity (ROE) of 18% and a dividend payout ratio of 35%. Assuming no external equity financing and stable capital structure, what is the company's sustainable growth rate?
- A18.00%
- B9.00%
- C6.30%
- D11.70%
Show answer & explanationAnswer & explanation
Correct answer: D. 11.70%
Sustainable growth rate = ROE × retention ratio (b). Retention ratio = 1 − payout ratio = 1 − 0.35 = 0.65. Sustainable growth = 0.18 × 0.65 = 0.117, or 11.70%.
Why the other options are wrong
- A. Incorrect; this simply restates ROE without adjusting for retention.
- B. Incorrect; this is half of ROE, not tied to the actual retention ratio calculation.
- C. Incorrect; this uses ROE × payout ratio (0.18×0.35) instead of ROE × retention ratio.
Sustainable Growth Rate
The rate at which a company can grow its equity (and dividends/earnings) without external equity financing, calculated as ROE multiplied by the retention ratio (g = ROE × b, where b = 1 − payout ratio).
- Formula: g = ROE × (1 − payout ratio)
- Used as the long-term growth input in DDM models
- Assumes constant ROE, payout ratio, and no new equity issuance
Memory trick: Keep more, grow more: retention times ROE.