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In the hands of an artful analyst, the popular model can yield valuable insights. But it can be abused and misused easily. Financial executives and their advisers should beware of six potential problems:

1 The model says nothing about value creation. The popular model describes the maximum growth rate in assets, not market value. All too often, financial advisers take for granted the wisdom of stated growth targets—but such growth targets are usually stated in terms of sales or assets and may be realizable only with the destruction of market value of equity and/or debt. The model should not be used without some complementary analysis proving the economic attractiveness of the growth goals. A much more detailed analysis of self-sustainable growth and its sources may be gained from a forecast of financial statements, or cash receipts and disbursements. The self-sustainable growth model is nothing more than a summary of such a forecast. This detailed model could be prepared as a computer spreadsheet with various operating and financial policy variables as assumptions or outputs, depending on whether the objective is to determine growth-sustaining policies or merely to compute the cash flow and time-value-adjusted self-sustainable growth rate.

2 The popular model is an accrual-accounting-based, one-year measure. ROE and ROTC are measured over one year, typically from historical performance. Can this performance be sustained over the long term into the future? Moreover, by focusing on reported earnings, the model ignores cash flow items such as deferred taxes, which might be the basis for much higher self-sustainable growth.

3 The popular model assumes fixed assets grow at the rate of sales. This would be inappropriate for firms whose fixed asset additions are large, lumpy, and intermittent. Also, firms that have spare productive capacity may not need to add assets in a particular year.

4 The popular model estimates the nominal self-sustainable growth rate; yet it is the real self-sustainable growth rate that is of strategic interest. Under inflation, the real growth rate will be smaller than the nominal rate, and indeed, could even be negative even though the nominal rate is large and positive. Roughly speaking, the real self-sustainable rate will be equal to the difference between the nominal self-sustainable rate and the rate of inflation.

5 The self-sustainable growth rate is no panacea. Rarely are the remedies indicated by the model easy to implement. This is because many of the variables in the model are exogenous to the firm: (1) interest rates are set in the capital markets; (2) product and factor prices are determined by competitive conditions; (3) internal programs to cut costs may be limited by managerial talent; and so on.

6 The assumption of only internal equity financing violates a basic premise of modern finance theory. The premise is that capital is always accessible to firms having profitable investment opportunities. Indeed, from a macroeconomic point of view, society should want managers to fund all profitable opportunities. Why managers choose to constrain their own growth is not well understood, though many of the reasons suggested at the opening of this note probably explain why: concerns about control, confidentiality, transaction costs, and so on. In any event, the fact is that the American business economy relies very little on equity financing: From 1950 to 1990, only 4 percent of all capital investment was financed by the sales of new equity. In short, even though equity capital is always accessible, most executives make little use of it.