CFA Level I Exam · Discounted Cash Flow (DCF) and Growth Models

Sustainable Growth Rate and Earnings Retention Explained

Updated 7 October 2026 · Fact-checked

The sustainable growth rate is the growth a company can fund from retained earnings without raising new equity or changing its leverage and margins. The formula is g = b × ROE, where b is the retention ratio (1 − payout ratio). Find b, find ROE, then multiply.

Understand Sustainable Growth Rate and Earnings Retention

A company can grow earnings only if it reinvests money. Retained earnings are the main source of that money. The share of net income kept in the firm is the retention ratio (b). The share paid out as dividends is the dividend payout ratio. They always add to 1: b = 1 − payout.

Reinvested money must earn something. Return on equity (ROE) tells you how much new net income each unit of equity produces. If you keep 60% of earnings and each unit of equity earns 15%, equity grows by 9% a year and so does earnings. That is the sustainable growth rate: g = b × ROE.

The word sustainable matters. The formula assumes the firm keeps the same ROE, the same payout policy and the same capital structure, and issues no new shares. Then equity grows at g, and earnings and dividends grow at g too.

ROE links to the DuPont breakdown: ROE = net profit margin × asset turnover × financial leverage. So growth rises when the firm retains more, earns higher margins, uses assets more efficiently or uses more leverage. Payout policy is the lever management controls most directly: paying more dividends lowers b and lowers g.

This g feeds the Gordon growth model and the P/E justification. A higher g raises value only if ROE is above the required return on equity. If ROE is below it, retaining more earnings destroys value even though g rises.

Key formulas to remember

Retention ratio: b = 1 − dividend payout ratio = (Net income − Dividends) ÷ Net income; Payout ratio = Dividends ÷ Net income. If the question gives dividends per share and EPS, use those.
Sustainable growth rate: g = b × ROE; Assumes constant ROE, constant payout, constant leverage and no new equity issued.
ROE: ROE = Net income ÷ Equity; Use the equity base stated in the question: beginning, average or ending. Check what is given.
DuPont (three-step) ROE: ROE = (Net income ÷ Sales) × (Sales ÷ Total assets) × (Total assets ÷ Equity); Net profit margin × asset turnover × financial leverage.
Growth from DuPont: g = b × net profit margin × asset turnover × financial leverage; Use this to see which driver changes growth.
Gordon growth link: V0 = D1 ÷ (r − g), with D1 = EPS1 × (1 − b); Requires r > g. Using g = b × ROE ties dividends and growth to the same policy.

How to solve Sustainable Growth Rate and Earnings Retention questions

Use this method for any question on retention, ROE and growth.

1Identify what is asked: g, b, ROE, payout or a DuPont driver.
2Write g = b × ROE and mark which two inputs you already have.
3Convert any payout information to retention: b = 1 − payout, or b = 1 − DPS ÷ EPS.
4If ROE is not given, compute it from net income and equity, or multiply the DuPont components.
5Compute g and keep it as a decimal until the end.
6If the question changes a driver (margin, turnover, leverage, payout), recompute ROE or b, then g, and compare.
7If valuation is involved, check that r > g and that ROE versus r makes sense before choosing the answer.

Quickest way: Two-number shortcut

When to use it: Any single-step growth question in the 90-second window.

Get b first: 1 minus payout.
Get ROE: given, or net income ÷ equity, or the DuPont product.
Multiply b × ROE and scan the three options, which are in ascending order.
If a wrong option equals payout × ROE, discard it; that is the classic trap.
For 'which change raises growth' questions, ask whether it raises b or ROE; if neither, growth is unchanged.

Common mistakes in Sustainable Growth Rate and Earnings Retention

Using the payout ratio instead of the retention ratio in g = b × ROE.
The question gives dividends, and students plug in the number they see.
Fix: Always convert: b = 1 − payout. Write b on its own line before multiplying.
Forgetting that g is only sustainable if ROE, payout and leverage stay constant and no new equity is issued.
The formula looks like a simple identity.
Fix: If a question says the firm issues shares or changes leverage, the formula no longer holds as stated.
Treating higher retention as always good for value.
Higher b gives higher g, so it feels better.
Fix: Value rises only if ROE exceeds the required return. If ROE is below r, more retention lowers value.
Mixing up the ROE equity base (beginning, average, ending).
Different questions give different balance sheet figures.
Fix: Use the base the question states. If it only gives one equity figure, use it.
Entering the DuPont leverage term as debt ÷ equity instead of assets ÷ equity.
Leverage is described loosely.
Fix: In DuPont, financial leverage = total assets ÷ equity. Check that margin × turnover × leverage equals net income ÷ equity.
Using percentages inconsistently, such as 0.6 × 15 and reading 9 as 9 percent in the wrong place.
Mixing decimals and percent under time pressure.
Fix: Convert everything to decimals, multiply, then read the result as a percentage.

Worked examples

Example 1

A company reports net income of $80 million and pays dividends of $32 million. Shareholders' equity is $400 million. Assuming ROE is based on this equity figure and stays constant, the sustainable growth rate is closest to: A. 8.0% B. 12.0% C. 20.0%

Show the solution

Payout ratio = 32 ÷ 80 = 0.40.
Retention ratio b = 1 − 0.40 = 0.60.
ROE = 80 ÷ 400 = 0.20.
g = 0.60 × 0.20 = 0.12, or 12.0%.
Option A (8.0%) is payout × ROE = 0.40 × 0.20, the payout trap. Option C is ROE alone, which assumes full retention.

Answer: B. 12.0%

Example 2

A firm has a net profit margin of 5%, asset turnover of 1.6 and financial leverage of 2.0. It pays out 25% of earnings. If the firm cuts its payout to 10% and nothing else changes, its sustainable growth rate changes from: A. 12.0% to 13.5% B. 12.0% to 14.4% C. 12.0% to 16.0%

Show the solution

ROE = 0.05 × 1.6 × 2.0 = 0.16.
Before: b = 0.75, so g = 0.75 × 0.16 = 0.12, or 12.0%.
After: b = 0.90, so g = 0.90 × 0.16 = 0.144, or 14.4%.
Option A (13.5%) would need b of about 0.84 (0.135 ÷ 0.16), which does not match a 10% payout.
Option C uses ROE (16.0%) as the ending growth rate, which would need full retention (b = 1). Cutting the payout to 10% gives b = 0.90, not 1.

Answer: B. 12.0% to 14.4%

Exam tips

Options are in ascending order and one is usually payout × ROE. Compute b before you look at the options.
For driver questions, name the driver first. Only b, margin, turnover and leverage change g in the DuPont version.
If a question asks whether retention adds value, compare ROE with the required return on equity.
Do the arithmetic in decimals and keep the calculator result until the last step.
With 90 seconds per question, skip re-deriving DuPont; just multiply the three given components.

Practice questions from Discounted Cash Flow (DCF) and Growth Models

Sustainable Growth Rate and Earnings Retention in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Sustainable Growth Rate and Earnings Retention: frequently asked questions

What is the sustainable growth rate formula?

g = b × ROE, where b is the retention ratio, 1 minus the dividend payout ratio. It gives the growth in earnings and equity that internal funds can support. It assumes constant ROE, payout and leverage, with no new equity issued.

How does the sustainable growth rate link to DuPont analysis?

ROE splits into net profit margin, asset turnover and financial leverage. So g = b × margin × turnover × leverage. This shows that growth comes from retaining more, earning higher margins, using assets better or using more leverage.

What is the difference between sustainable growth rate and internal growth rate?

The internal growth rate assumes the firm uses no external financing at all. It is usually written as b × ROA ÷ (1 − b × ROA), where ROA is return on assets. The sustainable growth rate, g = b × ROE, allows debt to grow along with equity so that leverage stays constant. For exam questions on this page, focus on g = b × ROE.

Does a lower dividend payout always raise a company's value?

No. A lower payout raises the retention ratio and growth. Value rises only if the firm earns an ROE above its required return on equity. If ROE is below that, retaining more earnings reduces value.