How to Calculate Sustainable Growth Rate Without Roe

Calculating sustainable growth rate without Return on Equity (ROE) requires using alternative valuation models. The Gordon Growth Model is particularly useful for this purpose, as it focuses on the company's expected earnings growth rather than equity metrics.

What is Sustainable Growth Rate?

The sustainable growth rate represents the long-term growth rate of a company's earnings that can be supported by its assets and operations. Unlike short-term growth, which may be driven by temporary factors, sustainable growth reflects the company's fundamental ability to generate profits.

In traditional valuation models, ROE is often used to estimate sustainable growth. However, when ROE data isn't available, alternative approaches like the Gordon Growth Model can be used to calculate sustainable growth rates.

Gordon Growth Model

The Gordon Growth Model is a valuation method that estimates the intrinsic value of a company's stock based on its expected future dividends and growth rate. The model assumes that dividends grow at a constant rate indefinitely.

Gordon Growth Model Formula:

Intrinsic Value = (Dividend × (1 + Growth Rate)) / (Discount Rate - Growth Rate)

Where:

Dividend - The most recent dividend payment
Growth Rate - The expected sustainable growth rate
Discount Rate - The required rate of return (typically the company's cost of equity)

The Gordon Growth Model is particularly useful when ROE data is unavailable because it focuses on dividend growth and discount rates rather than equity metrics.

Calculating Without ROE

When ROE data isn't available, you can estimate the sustainable growth rate using the Gordon Growth Model by following these steps:

Estimate the company's expected dividend growth rate based on industry trends and company fundamentals.
Determine the company's cost of equity (discount rate) using methods like the Capital Asset Pricing Model (CAPM).
Use the Gordon Growth Model formula to calculate the intrinsic value of the company's stock.
Compare the calculated intrinsic value to the current market price to determine if the stock is undervalued or overvalued.

Note: The Gordon Growth Model assumes that the company's dividend growth rate remains constant indefinitely. In reality, growth rates may change over time, so this model should be used with caution.

Example Calculation

Let's walk through an example calculation using the Gordon Growth Model to estimate a company's sustainable growth rate without ROE data.

Assume the following values:

Most recent dividend (D₀) = $2.00
Expected growth rate (g) = 5% or 0.05
Discount rate (k) = 10% or 0.10

Intrinsic Value Calculation:

Intrinsic Value = ($2.00 × (1 + 0.05)) / (0.10 - 0.05) = $2.10 / 0.05 = $42.00

In this example, the Gordon Growth Model estimates that the company's stock is worth $42.00 based on its expected dividend growth and discount rate. If the current market price is below $42.00, the stock may be undervalued, suggesting a sustainable growth rate of 5% is reasonable.

FAQ

Can the Gordon Growth Model be used for all types of companies?: The Gordon Growth Model works best for companies that pay dividends and have stable growth rates. For companies that don't pay dividends or have highly variable growth rates, alternative valuation models may be more appropriate.
How accurate is the sustainable growth rate calculated using the Gordon Growth Model?: The accuracy of the sustainable growth rate depends on the accuracy of the inputs used in the model, such as the expected dividend growth rate and discount rate. It's important to use reasonable estimates based on industry trends and company fundamentals.
What are the limitations of using the Gordon Growth Model without ROE data?: The Gordon Growth Model assumes that the company's dividend growth rate remains constant indefinitely, which may not be realistic. Additionally, the model relies on estimates of the discount rate, which can be difficult to determine accurately.
How can I improve the accuracy of the sustainable growth rate calculation?: To improve the accuracy of the sustainable growth rate calculation, consider using multiple valuation models and comparing the results. Additionally, use historical data and industry benchmarks to refine your estimates of the dividend growth rate and discount rate.
When should I use the Gordon Growth Model instead of other valuation models?: The Gordon Growth Model is particularly useful when ROE data is unavailable or when you want to focus on dividend growth and discount rates rather than equity metrics. It's also useful for companies that pay dividends and have stable growth rates.