Long-Term Growth and Value

Why an assumption of long term growth is critical to a business valuation
November 4, 2022

In the last email I wrote about the role of risk and growth in determining the value of a business. You may recall the Gordon Growth Model:

Value = Cash Flow/(Discount Rate %- Growth Rate %)

Based on this formula, a high growth rate increases value, even of a risky business. And low growth expectations can depress the value of an otherwise low risk investment.

This time, I wanted to focus on what determines the growth rate that is used in this formula.

The first thing to understand is that the appropriate growth rate is a long-term growth rate-this is not the rate of growth that a business might expect to achieve in the next five or 10 years but effectively, the growth rate that will govern the business into perpetuity.

There are some generally accepted boundaries within which this growth rate will fall. At the bottom end of the range is the consensus estimate for the long-term inflation rate. This assumes that the company’s cash flows would just keep pace with the general level of expected inflation and not experience any real growth. The inflation rate has averaged 2.9% a year from 1926 to 2018.

The upper end of the range is effectively limited to the estimated inflation rate plus the expected real growth in the gross domestic product (“GDP”) of the United States. Due tote magic of compounding, and the fact that perpetuity is a very long time, if the growth rate exceeds this level, then theoretically the company’s value could exceed the GDP some point in the future. Historically, the average annual growth in GDP from 1926 to 2018 has been 3.2% which implies that currently the upper limit of the applicable growth rate is 6.1%.

A survey which asked valuation professionals the general range of the long-term growth rates that they used showed the following:

  • 3% or Less = 40%
  • 3% - 5% = 55%
  • 3% - 6% = 4%
  • Other = 1%

The survey results show that very few valuation professionals are willing to use a growth rate which reaches the top of the current range - if the economy is made up of high growth and stable growth firms then the growth rate of the stable growth firms will likely be lower than the growth rate of the economy as a whole.

Why should we care? Well, doing the math, if a company is being valued with a discount rate of 18%,then the value would be 27% higher using a growth rate of 6.1% versus 2.9% - a pretty significant impact on value.

In some circumstances it might be appropriate to use a growth rate less than the inflation rate, but this would imply that the company is in a state of terminal decline. And infare circumstances a negative growth rate may be appropriate if a discrete endow the cash flows can be forecasted e.g. a patent expiring or the exhaustion of petroleum reserves.

The ultimate determination of the growth rate used in the valuation will reflect the company’s unique characteristics and the state of the market in which it operates. For example, if the company expects to have higher growth in the near future, the valuation analyst may select a growth rate towards the higher end of the range to reflect an average of higher short-term rates falling to lower rates in the long run. Alternatively, if prospects are relatively modest, the rate closer to the inflation rate maybe appropriate.