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As a shorthand for estimating the self-sustainable growth rate, many analysts use the model shown in equation (2) and its variants, equations (3 and 4):

(2)

(3)

(4)

In the formulas, ROE is the accounting return on equity, ROTC is return on total capital¹⁷, Kd is the after-tax cost of debt, and DPO is the dividend payout ratio.¹⁸ Equation (2) is simply an accrual-accounting version of M&M’s formula: (1 – DPO) is equivalent to M&M’s K. For ROE, many analysts use the expected return for the next few years. A less sensible assumption is to use the past few years’ average ROE.

Equation (3) expands the preceding equation by inserting a well-known formula for the ROE of a levered firm. The virtue of this form of the model is that it allows the analyst to tinker with a possible interdependence between the firm’s mix of capital and its cost of debt. For instance, the firm’s cost of debt might be supposed to rise as the firm increased its debt/equity ratio past some moderate level.

Equation (4) also expands equation (2) by inserting the well-known DuPont system of ratios for ROE. This version is appealing to operating managers since it decomposes ROE into a measure of margin profitability (net income/sales), a measure of asset turnover (sales/assets), and a measure of leverage (assets/equity). With the aid of this model, one can see more directly the effects of price or cost improvements and better asset utilization.