Determinants of the sustainable growth rate
Monetary policy guidelines, industry forecasts and long-term growth rates of comparable companies, taking into account the individual circumstances of the valuation object, provide the first essential indications. However, the valuer should always assess the following determinants of sustainable profit growth in order to determine the sustainable growth rate:
- Volume growth: What increase in sales volumes can the company realize in the long term?
- Pricing leeway: What options does the company have to pursue an autonomous pricing policy and pass on cost increases to its customers?
- Production efficiency: How can the company shape the relationship between the production factors used and the quantity sold in the long term?
Profit growth is the result of all of these determinants and can therefore be fed by all or only some of them. A negative development of individual effects can be compensated for by others.
Why the sustainable growth rate matters for value
The sustainable growth rate is particularly important because it directly affects the value attributed to the period after the detailed planning phase. In a DCF valuation or Income approach, even a small change in the long-term growth assumption can have a material effect on enterprise value because the growth rate is applied over an indefinite period.
The relationship becomes especially clear in the terminal value: a higher sustainable growth rate increases the expected future cash flow while simultaneously reducing the difference between the discount rate and growth rate used to capitalize that cash flow.
Mini-example: what does +0.5 percentage points mean?
Consider a simplified perpetuity with:
- sustainable annual cash flow: €10 million
- discount rate: 8%
- sustainable growth rate: 1.0%
The terminal value is:
€10m × 1.01 / (8% − 1%) = €144.3m
If the sustainable growth rate increases by 0.5 percentage points to 1.5%:
€10m × 1.015 / (8% − 1.5%) = €156.2m
The 0.5 percentage-point increase therefore raises the terminal value by approximately €11.9 million, or 8.2%, before considering any other valuation adjustments.
This illustrates why the sustainable growth rate should not be selected as a mechanical assumption. Small changes can have a disproportionate effect on value when the discount rate and growth rate are relatively close.
✅ For the mechanics behind the terminal value, see our article on The Perpetual Annuity in Business Valuation. The relationship between the terminal value, investments and depreciation is discussed in Perpetuity: Investments and Depreciation.
Perspective: short and medium term vs. long term
In the short term, all three influencing factors are strongly determined by the current state of the company and the management’s immediate options for action. In the medium term, the strategic influence of management becomes more important, whether through investment decisions, changes to the sales strategy or new product developments. However, both short and medium-term measures are regularly already reflected in the detailed planning phase and are therefore less of an issue when determining the sustainable growth rate.
In the long term, the determinants of sustainable growth are generally influenced by the market in which the company operates and the competitive structure.
In young markets, there is often scope for business expansion and aggressive pricing policies. Rising purchase prices can generally be passed on, and production efficiency is not yet a central aspect of corporate management.
In more mature markets, volume growth is often only possible at the expense of competitors and is accompanied by a more cautious pricing policy. Competitive structures are usually more established and production efficiency is often the key success factor here.
The sustainable growth rate should therefore reflect what the company can reasonably maintain over the long term—not simply extrapolate the growth achieved during its detailed planning period.
Determination of the sustainable growth rate
Consciously or unconsciously, the determination of the sustainable growth rate always involves the valuer taking a position on sustainable volume growth, pricing scope and increasing the production efficiency of the valuation object.
If the valuer is unable to make a determination without further ado due to a lack of market data, it is always advisable to adopt as neutral a position as possible.
This can consist of assuming no volume growth and no increase in production efficiency. It is then also advisable to assume an average scope for price setting. A good indicator under these assumptions is the general inflation expectation. Here there is no quantity effect per se, and the implicit price effect lies in the “middle of the economy”.
This does not mean that the sustainable growth rate should simply be set equal to inflation. The relevant question is whether the valuation object can sustainably pass through price increases, improve productivity or expand volumes without assuming an increasingly dominant market position. The rate should therefore be consistent with the company’s long-term competitive position, market maturity and expected economic conditions.
Consistency with the discount rate
The sustainable growth rate should always be assessed together with the discount rate. Both assumptions describe the economics of the same long-term period and should therefore be internally consistent.
In particular, the valuer should avoid implicitly assuming a high long-term nominal growth rate while using a discount rate that reflects materially different inflation or economic assumptions.
This is one reason why the determination of the sustainable growth rate cannot be separated entirely from the broader cost-of-capital analysis.
Wrap it up!
The sustainable growth rate is a central factor in business valuation and directly affects the terminal value in both the Income approach and DCF method. Careful analysis of volume growth, pricing scope and production efficiency helps valuers set a realistic and well-founded rate.
In the absence of specific market data, a neutral position based on general economic indicators such as inflation can provide a useful starting point. However, the final assumption should remain consistent with the company’s market, competitive position, long-term economics and the discount rate used in the valuation.
