Which sustainable growth rate is best at forecasting actual growth?

Abstract

Purpose

Using various proxies for the firms' return on equity (ROE) and retention ratios (b) the authors calculate 36 sustainable growth rates, on a rolling basis, for a comprehensive set of firms over a 52-year period. The authors then assess the ability of these different sustainable growth rates to predict the actual, out-of-sample, five-year growth rates of the firms' earnings.

Design/methodology/approach

The authors compare the forecast to determine which method of estimating ROE and b produce the lowest mean-squared-errors and then determine the estimation method that works best for firms with different characteristics and for firms in different industries.

Findings

Overall, using the median ROE of all firms in the market and the 5-year average of the specific firm's retention ratio produces the lowest, statistically significant, forecast errors. Variations are documented based on firm characteristics, including dividend payout, level of ROE and industry.

Practical implications

The findings can guide practitioners in using the best earnings forecasting method.

Originality/value

Financial textbooks seem universally to suggest that one method of estimating the growth rate of a firm's earnings is to calculate the “sustainable growth rate” by multiplying the firm's ROE by the firm's b. At the same time, multiple methods of proxying for both ROE and b have been suggested; therefore, it is an interesting and useful empirical question, which, heretofore, has not been addressed in the literature, as to which estimation of the sustainable growth rate best approximates the actual future growth of the firm's earnings. The findings can guide practitioners in using the best earnings forecasting method.

Citation

Moore, G. and Simpson, M.W. (2023), "Which sustainable growth rate is best at forecasting actual growth?", American Journal of Business, Vol. 38 No. 4, pp. 173-192. https://doi.org/10.1108/AJB-12-2022-0196