Estimating Sustainable Growth from ROA, Leverage, and Payout

Summary

The answer derives a stock growth estimate by linking return on equity to return on assets and financial leverage, then multiplying by the earnings retention rate. It starts from the DuPont relationship: return on equity equals return on assets times total assets divided by shareholders’ equity. The retention rate is one minus the dividend payout ratio, so the given payout leaves 40% of earnings retained. Applying the stated inputs yields an estimated growth rate of 12.8%.

This is a simplified sustainable growth calculation, not a forecast validated against company results. It assumes the supplied profitability, leverage, and payout measures are representative and persist. The answer also notes that rigorous calculations may use average assets and average equity because balance sheet values change during the period. The estimate therefore serves as a formula illustration; actual growth can differ if profitability, financing, payout policy, or other conditions change.

Key ideas

• Return on equity can be expressed as return on assets multiplied by financial leverage.
• The retention rate equals one minus the dividend payout ratio.
• The sustainable growth estimate is retention multiplied by return on equity.
• Using period average balance sheet values can better reflect changes during the year.

Tags

# Computing the expected stock growth rate


# Computing the expected stock growth rate












I need to compute the expected growth rate of a stock given the data: financial leverage 2.0 return on assets 16% dividend payout ratio 60%

I don't know how to compute it nor where to start, could you please help me?

## Answer by Themis Z (score 2)

https://quant.stackexchange.com/a/22457

Lets start with the Return on Equity (RoE) formula as you already have some of the information given:

RoE = (Net Income/Sales)x(Sales/ Total Assets)x(Total Assets/Shareholders' equity)

Now the first two terms describe the Return on Assets (take out the Sales from the denominator of the first fraction and from the numerator of the second fraction):

RoA = Net Income/Total Assets and we know RoA = 0.16

Your financial leverage ratio is Total Assets/Shareholders' equity = 2.0. Your retention rate is b= 1-payout ratio = 1-0.60 =0.40

The last equation we need is the one for the growth rate: g = b x ROE =0.40 x 2.0 x 0.16 =0.128 or 12.8%

I hope it helps, if you can get access to CFA material (paid or publicly available) go through it as it explains it all well (any and all mistakes here are solely mine of course :-) ...)

Note also that some sources talk about Average Total Assets and Average shareholders equity etc which is the complete and correct way of calculations as they can and do change in the course of a financial year. I kept above formulas simple but one still gets the gist I hope...

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.