The rate you expect discretionary cash flows to increase year over year is known as the growth rate. In particular, the growth in cash flows which is expected to continue forever is called the sustainable growth rate. In the context of valuing a startup we would generally have at least two phases of growth. A high growth period while the company is expanding and grabbing market share and a sustainable growth rate expected once this rapid growth declines upon market saturation.
Here we will focus on determining the sustainable growth rate which is used for in the capitalized cash flow valuation methodology and for determining the terminal value in a DCF model.
Upper and Lower Limits
When thinking about the sustainable growth rate remember it is the growth you expect to occur forever. Knowing that we are dealing with a long term rate we can define guidelines for the upper and lower limits of the rates.
When performing valuation techniques we use nominal discretionary cash flows, discount rates and capitalization rates (not adjusting for inflation). Thus, we should expect cash flows to at least grow with inflation. So the sustainable growth rate should at minimum equal the long term inflation rate.
As an estimate of the long term inflation rate we can use the 2% long run average from the Federal Reserve.
Since we are looking at the long term growth rate of a company we can assume that it cannot maintain a growth rate greater than the growth of the economy as a whole. This makes logical sense. If a company has a long term growth higher than the economy as a whole it would eventually (in the very-very long term) grow larger than the economy. So, generally, it is a good idea to ensure the growth rate is not too out of line with the long term growth of the economy.
For simplicity we can use the estimated long term GDP growth of 2.2% plus the long term inflation rate of 2% as estimated by the Federal Reserve. This leaves us with an upper limit of 4.4% for our growth rate.
We now have the upper and lower bounds for our sustainable growth rate leaving us with the hardest task – determining and supporting the exact growth rate. Remember, telling the future is always tough! Most importantly use your own ideas to determine the growth rate that you deem most appropriate. To get you started you can consider the following techniques.
When it comes to companies and stocks in general, history doesn’t always repeat itself. However, looking at historical growth rates can help give us a starting point for our analysis. When calculating the growth rate remember to remove any non-recurring expenses. For example, if the company wins a major lawsuit it may result in increased cash flows and/or earnings. These effects should be backed out when calculating the growth rate since we can’t expect this event to occur again in the future.
One popular method of analysis is to compare the 10 year, 5 year, 3 year and 1 year growth rates of a given metric. This can help show if growth has started recently, dropped off or remained stable in the medium term. If we notice stable high growth this will suggest that we should choose a growth rate towards the upper limit of our growth rate range.
You should also look for any available industry and government forecasts when determining the sustainable growth rate. For example, if you are valuing a utility company then you should analyze forecasts of energy consumption in the region. These studies are useful because they can show you the long term growth of energy consumption which will drive the growth of your company.
The forecast may show a trend more energy efficient homes in the area. If there is no expected growth in the number of households then there will likely be low growth in the company. Alternatively if there are large population growth expected in the long term then the opposite may be true. Often these studies do the legwork and provide a good estimate of the growth potential of a company.
Obviously you will need to determine what metrics you think will indicate growth in the specific company you’re looking at. Also, you may need to get creative since there are only a limited number of studies and forecasts available to you.
Finalize that Growth Rate
The final step is to finalize your sustainable growth rate based on all the information available to you. It’s often best to be conservative with your growth rate since you are suggesting it will continue forever. Remember, use your common sense and gather as much relevant information as practical.