Chartered Financial Analyst (CFA) Practice Exam Level 2

What occurs when the stock implied growth rate exceeds the Sustainable Growth Rate?

1. The stock is considered undervalued

2. The stock is considered overvalued

3. The stock is classified as a safe investment

4. The stock is expected to decline

The correct answer is: The stock is considered overvalued

When the stock implied growth rate exceeds the Sustainable Growth Rate, it indicates that investors are expecting the company to grow at a rate that is not sustainable over the long term. The Sustainable Growth Rate is calculated based on a company's return on equity and its retention ratio (the proportion of earnings retained in the business rather than paid out as dividends). This rate reflects the maximum growth a company can sustain without needing to increase its financial leverage or issuing new equity. When the implied growth rate surpasses this sustainable rate, it suggests that the market has overly optimistic expectations for future growth. In such scenarios, stocks are often deemed overvalued. This is because the market price of the stock may be artificially inflated based on unrealistic growth projections that the company may not be able to deliver sustainably. Consequently, if the actual growth does not meet these high expectations, the stock price may correct downward, leading to potential losses for investors. By understanding this relationship between implied growth rate and sustainable growth rate, investors can assess whether a stock is likely to experience a price correction and position themselves accordingly.