Growth Analysis
Sustainable Growth Rate Modeling — From Retention Ratio to DCF Projection
The growth rate is the single most subjective and consequential assumption in a DCF. Equitest's Growth Analysis module derives sustainable growth rates from the company's own financial fundamentals — retention ratio, ROE, and reinvestment rate — cross-referenced against industry benchmarks and macro anchors, and stress-tested across four Damodaran growth pattern types.
What Is the Sustainable Growth Rate?
The sustainable growth rate is the maximum rate at which a company can grow its revenues and earnings without requiring external financing — i.e., funded entirely from retained earnings reinvested at the existing return on equity. It is the theoretically sound anchor for the explicit-period growth assumption in a DCF and is derived directly from the company's own financial fundamentals rather than being assumed arbitrarily.
The fundamental formula is g = ROE × b, where ROE is the return on equity and b is the retention ratio (the proportion of earnings retained rather than distributed as dividends). A company earning 15% ROE and retaining 60% of earnings has a sustainable growth rate of 9%. If the analyst assumes a higher growth rate in the DCF without justification, the model implicitly assumes the company can grow faster than its own economics support — a common and often undetected source of overvaluation.
For companies with debt financing, the equivalent formula using total capital is g = ROIC × reinvestment rate, where ROIC is the return on invested capital and the reinvestment rate is the share of NOPAT reinvested back into the business. Equitest computes both metrics and uses the more conservative of the two as a cross-check on the analyst-entered growth assumption.
The Sustainable Growth Rate Formula
How Equitest Implements Growth Analysis
Chapter 22 derives, cross-validates, and stress-tests the growth assumption across four Damodaran growth pattern types — transforming a single arbitrary input into a fundamentally anchored, documented assumption.
ROE × Retention Ratio from Historical Financials
Equitest computes ROE and the retention ratio from the normalized historical financials entered in earlier chapters. The sustainable growth rate g = ROE × b is calculated for each historical year and averaged — providing a company-specific, fundamentally grounded base growth estimate. ROIC and reinvestment rate are computed in parallel as a cross-check. When the two methods agree, the analyst has strong justification for the growth assumption.
Cross-Referenced Against Damodaran Sector Growth
The company's fundamental growth rate is cross-referenced against Damodaran's sector-level historical and expected revenue growth data. If the company's implied sustainable growth rate significantly exceeds the sector median, Equitest flags this for analyst review — requiring documented justification for above-market growth assumptions, the most common source of DCF overvaluation in practice.
Stable, Two-Stage, Three-Stage, High-Growth-to-Stable
Following Damodaran's framework, Equitest supports four growth pattern types: (1) Stable — constant growth throughout the projection period, appropriate for mature companies; (2) Two-Stage — high growth for years 1–5 declining to stable terminal growth; (3) Three-Stage — high growth, transition, then stable; (4) High-Growth-to-Stable — rapid early growth converging smoothly to a long-run rate. The analyst selects the pattern that best reflects the company's competitive position and lifecycle stage.
Bottom-Up Revenue Input Alternative
For companies with detailed bottoms-up revenue models — unit economics, contract pipeline, or subscription cohort data — Equitest allows direct revenue input mode: the analyst enters explicit revenue projections for each year rather than applying a growth rate. Equitest then derives the implied growth rate, validates it against the sustainable rate, and uses the direct revenues as the FCF projection base in Chapter 24.
Inflation and GDP as Terminal Growth Ceiling
No company can grow faster than the economy indefinitely — a terminal growth rate above the long-run nominal GDP growth rate implies the company will eventually exceed the entire economy in size. Equitest enforces this logic by displaying the long-run expected GDP growth rate and inflation rate as the theoretical ceiling for the terminal growth assumption. If the analyst enters a terminal growth rate above this ceiling, the system raises a compliance warning.
Feeds Directly into DCF Growth Assumptions
The growth pattern type and growth rates finalized in Chapter 22 flow automatically into Chapter 23 (DCF Growth Assumptions), where they populate the year-by-year FCF projection table. Chapter 23 allows per-year overrides with documented rationale — so the analyst can refine individual year projections while maintaining the Chapter 22 fundamental framework as the underlying analytical foundation.
