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CFA Level II Exam · Discounted Dividend Valuation

Sustainable Growth Rate and Dividend Growth Explained

Updated 7 October 2026 · Fact-checked

The sustainable growth rate is the growth a firm can fund from retained earnings without raising new equity or changing leverage. It equals retention rate × ROE, where retention = 1 − payout ratio. Expand ROE with DuPont (margin × turnover × leverage) to see what drives growth, then use g in the Gordon growth model.

Understand Sustainable Growth Rate and Dividend Growth

A firm grows its earnings and dividends by reinvesting profit. If it pays out most earnings, little is left to reinvest, so growth is slow. If it keeps most earnings and earns a high return on them, growth is faster.

That link gives the core formula: g = b × ROE. Here b is the retention rate, the share of earnings kept. The dividend payout ratio is the share paid out. They always add to 1, so b = 1 − payout.

The result is called the sustainable growth rate when the firm keeps its capital structure (debt-to-equity) stable and issues no new equity. Retained earnings add to equity, and the firm borrows in proportion to keep leverage constant. ROE then applies to the whole equity base, so earnings grow at b × ROE.

The DuPont breakdown shows what sits inside ROE. ROE = net profit margin × asset turnover × financial leverage. So growth rises with higher retention, better margin, faster asset turnover or more leverage. This helps you judge whether a growth forecast is realistic.

In practice you use g in the Gordon growth model: V0 = D1 ÷ (r − g). The exam often asks you to compute g from vignette data, then value the stock or compare it with an analyst's growth forecast. Use ROE based on beginning or average equity only as the question states; otherwise use the ROE given.

Key formulas to remember

Retention rate
b = 1 − dividend payout ratio = 1 − (D ÷ EPS)
Payout and retention add to 1. Retention can also be (NI − dividends) ÷ NI.
Sustainable growth rate
g = b × ROE
Assumes stable capital structure, no new equity issued, and ROE constant.
DuPont ROE (three-step)
ROE = (NI ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity)
Margin × turnover × leverage. Use inside g = b × ROE.
Five-step DuPont ROE
ROE = (NI ÷ EBT) × (EBT ÷ EBIT) × (EBIT ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity)
Tax burden × interest burden × EBIT margin × turnover × leverage.
Gordon growth value
V0 = D1 ÷ (r − g) = D0 × (1 + g) ÷ (r − g)
Valid when g < r and growth is constant.
Implied payout and growth link
Payout = 1 − g ÷ ROE
Rearranged g = (1 − payout) × ROE. Use it to find the payout needed for a target g.

How to solve Sustainable Growth Rate and Dividend Growth questions

Use this order for any question on growth from retention and ROE.

  1. 1Find the payout ratio from the vignette: dividends ÷ net income, or DPS ÷ EPS.
  2. 2Compute the retention rate b = 1 − payout.
  3. 3Find ROE. If it is not given, build it from DuPont: margin × turnover × leverage, or net income ÷ equity.
  4. 4Check whether the question asks for beginning, average or ending equity, and use that consistently.
  5. 5Compute g = b × ROE.
  6. 6If DuPont changes are given, recompute ROE with the new components and then g.
  7. 7If valuation is asked, compute D1 = D0 × (1 + g) and apply D1 ÷ (r − g), checking g < r.
  8. 8Sanity check: g should be below ROE and below r.

Quickest way: Retention times ROE shortcut

When to use it: Use when the vignette gives payout or dividends plus ROE or its DuPont parts, and you need g fast.

  1. Write b = 1 − payout in one line.
  2. Multiply the three DuPont ratios to get ROE only if ROE is not given.
  3. Multiply b × ROE.
  4. For a target g, solve payout = 1 − g ÷ ROE.
  5. Eliminate options where g exceeds ROE or where the sign of a change is wrong.

Common mistakes in Sustainable Growth Rate and Dividend Growth

  • Using the payout ratio instead of the retention rate in g = b × ROE.

    Dividend data is given in the vignette, so students plug it in directly.

    Fix: Always write b = 1 − payout first. Growth comes from what is kept, not paid.

  • Using ROA instead of ROE.

    DuPont lists several ratios and students pick the wrong one.

    Fix: Growth from retained earnings uses ROE. Multiply by leverage if you only have ROA.

  • Forgetting to multiply by (1 + g) to get D1 in the Gordon model.

    The vignette gives the latest dividend D0.

    Fix: Check the dividend's timing. Use D1 = D0 × (1 + g) when D0 is the last paid dividend.

  • Treating g = b × ROE as valid with new equity issuance or changing leverage.

    The formula is memorised without its conditions.

    Fix: Remember it assumes stable capital structure and no new equity. Say so when a question changes those facts.

  • Mixing percentages and decimals, such as 40 × 0.15.

    Ratios appear as percents in the vignette.

    Fix: Convert everything to decimals before multiplying, then convert back.

  • Computing a DuPont ROE with inconsistent bases, such as average assets with ending equity.

    Exhibits show several balance sheet dates.

    Fix: Use the same basis for all components, matching the question's instruction.

Worked examples

Example 1

Vignette: Nordhaven AG reported net income of €80 million and paid dividends of €32 million. Its net profit margin is 8%, total asset turnover is 1.25 and financial leverage (assets ÷ equity) is 1.6. Q1: What is the retention rate? Q2: What is the sustainable growth rate? Q3: If net profit margin rises to 10% with all else unchanged, what is the new sustainable growth rate?

Show the solution
  1. Q1: Payout = 32 ÷ 80 = 0.40. Retention b = 1 − 0.40 = 0.60.
  2. Q2: ROE = 0.08 × 1.25 × 1.6 = 0.16. g = 0.60 × 0.16 = 0.096.
  3. Q3: New ROE = 0.10 × 1.25 × 1.6 = 0.20. Retention is unchanged at 0.60, so g = 0.60 × 0.20 = 0.12.

Answer: Retention rate 60%; sustainable growth rate 9.6%; with 10% margin, 12.0%.

Example 2

Vignette: Calderon Foods has ROE of 15% and expects next-year earnings per share of $4.00. It follows a constant payout of 30%. Investors require a return of 11%. Q1: What is the sustainable growth rate? Q2: What is next year's dividend? Q3: What is the Gordon growth value per share?

Show the solution
  1. Q1: b = 1 − 0.30 = 0.70. g = 0.70 × 0.15 = 0.105.
  2. Q2: D1 = 0.30 × 4.00 = $1.20.
  3. Q3: V0 = D1 ÷ (r − g) = 1.20 ÷ (0.11 − 0.105) = 1.20 ÷ 0.005 = $240.00.
  4. Check: g (10.5%) is below r (11%), so the model applies, though the value is very sensitive to g.

Answer: g = 10.5%; D1 = $1.20; value = $240.00 per share.

Exam tips

  • Write b = 1 − payout before anything else; this single step avoids the most common lost mark.
  • When a vignette gives DuPont parts, multiply them for ROE rather than hunting for a stated ROE that may be for a different year.
  • Always check g < r before using the Gordon model; a value that looks huge signals g is close to r.
  • If a question changes margin, turnover or leverage, recompute ROE only; retention stays the same unless the dividend policy changes.
  • Read whether the vignette says growth is funded without new equity; if new equity is issued, g = b × ROE does not apply directly.

Sustainable Growth Rate and Dividend Growth 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 Dividend Growth: frequently asked questions

What is the sustainable growth rate formula in CFA Level II?

It is g = b × ROE, where b is the retention rate (1 − payout ratio). It gives the growth a firm can fund internally while keeping leverage stable and issuing no new equity.

How do I calculate the sustainable growth rate using DuPont?

Compute ROE as net profit margin × asset turnover × financial leverage, then multiply by the retention rate. The five-step DuPont version works the same way but adds tax and interest burden.

How are retention rate and dividend payout ratio related?

They sum to one. Retention rate = 1 − payout ratio. A firm that pays out 40% of earnings retains 60%.

Can the sustainable growth rate be higher than ROE?

Not when retention is between 0 and 1, since g = b × ROE. It equals ROE only if the firm retains all earnings, which is rare and means no dividends.