Chartered Financial Analyst (CFA) Level 1 Practice Exam

What formula represents the sustainable growth rate?

1. Retention rate + ROE

2. Retention rate x ROA

3. Retention rate x ROE

4. Cash flow from operations x Dividend payout ratio

The correct answer is: Retention rate x ROE

The sustainable growth rate (SGR) is the rate at which a company can grow its sales, earnings, and dividends while maintaining its current financial structure, primarily represented by its return on equity (ROE) and retention ratio. The key formula to determine the sustainable growth rate is: Sustainable Growth Rate = Retention Ratio x Return on Equity (ROE) The retention ratio is the proportion of earnings that is retained in the business after dividends are paid out, essentially indicating how much profit is reinvested. ROE, on the other hand, reflects how efficiently a company uses its equity to generate earnings. This formula shows how a company can grow through internal resources, without needing to resort to external financing. By multiplying the retention ratio by ROE, we obtain the growth rate that is sustainable given the company's current operation and payout strategy. In contrast, the other choices lack this critical connection between the components of sustainable growth. For example, retention rate plus ROE does not properly address the context of growth in relation to what portion of earnings is reinvested. Similarly, retention rate multiplied by return on assets (ROA) is not relevant as ROA measures how effectively assets generate profit, not equity. Lastly, cash flow from operations