Key Drivers of Value - Part 4

The Growth Rate

In recent postings in this article series, we discussed two of the three value components in the equation below (commonly referred to as the Gordon growth model), the benefit stream and the discount rate.  In this article, we would like to cover the third and final component, the long-term sustainable growth rate.

Let's briefly review the definitions of the three variables in the Gordon model:

Key Drivers of Value

  • Benefit Stream.  This variable is some measure of income or economic benefit that an investor can expect to receive from the subject being valued.
  • Discount Rate.  This variable is the rate of return required by an investor to compensate him or her for his/her risk in not receiving the expected economic benefit.  The discount rate is also referred to as the cost of capital.
  • Long-Term Growth.  This variable is the expected level of growth of the benefit stream into perpetuity.

The second term in the denominator, long-term growth, measures the expected growth in the benefit stream.  In other words, the long-term growth rate seeks to measure the potential of the business to continue to increase the magnitude of its returns.  A word of caution:  The long-term growth rate component is one of the most critical subjective areas in the use of the income approach within the valuation discipline and requires significant professional judgment.

As defined above, the long-term growth rate involves the concept of "perpetuity," or infinity.  Whereas prevalent economic and industry forecasts tend to state growth in terms of the near to medium term (three to five years), the growth rate used in the Gordon model encompasses an infinite timeline.  While an appraiser will typically look at industry growth rates published by any number of research firms, such as IBISWorld, in developing his/her subject company's long-term growth rate, he/she will always keep in mind that the published growth rates are not into perpetuity.

Care must also be taken when referring to published growth rates and whether the rates are nominal or real growth rates; i.e., does the rate contain an inflation component (nominal), or does it attempt to capture only the volume growth (real)?  For example, IBISWorld provides the real rate of expected industry growth, which excludes an inflation component.  Case in point:  In employing the income approach, we at Acclaro will typically start with the IBISWorld estimate for a given industry, factor in our long-term growth estimate based on national and local (if applicable) economic forecasts as well as our and management's future growth expectations for the subject company, and finally add an inflation component of approximately 2.5% in arriving at the long-term sustainable growth rate used in our value equation.

Appraisers typically use a long-term sustainable growth rate that lies somewhere between 2.5% and 6%.  Using a rate of 2.5% is akin to stating that you do not expect the subject company to have any real growth (i.e., volume of units sold) into perpetuity, while using a rate of 6% is the same as stating that the subject company will grow long term at the upper end of the range of growth rates experienced by the U.S. economy as a whole since 1926.  For an appraiser to use a growth rate outside of this range is comparable to stating that the subject company will either have negative volume growth on average into perpetuity or will grow at a rate greater than the U.S. economy, which means that, theoretically speaking, one day in the very distant future the subject company's output will exceed that of the gross domestic product of the U.S.  This last point underscores the concept of "perpetuity" and how long that corresponding time period really is as well as how powerful the concept of compounding is!

In addition, the geographic market territory of a company can be a significant factor in determining the expected growth rate.  Companies that operate in a localized market territory generally have growth rates limited to the rate of inflation plus the long-term expected population growth rate.  Growth rates for companies whose geographic market territory is regional or national are based on the expected nominal growth rate for the industry plus or minus a couple of percentage points for company specific factors.  Large national or international companies will generally have higher growth rates that are more in line with the national GDP growth rate.

Let us wrap up our discussion of the long-term growth rate, the third and final component of the Gordon growth model, with a few key points:

  • The growth rate in this model is into perpetuity, whereas most economic and industry forecast growth rates are only for the next three to five years.
  • The growth rate in this model is a nominal, as opposed to a real, value that captures the expected average inflation rate over time.
  • Appraisers typically use a long-term sustainable growth rate of between 2.5% and 6% when employing the income approach to valuation.
  • The growth rate is normally constrained by a company's geographic market boundaries.

 

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