Earnings growth rate effect on terminal value
An often overlooked part of the discounted cash flow method analysis is estimation of the long-term business earnings growth rate. This important factor affects the so-called terminal value of the business. It is the residual value of a going concern that is added on top of discounted cash flows when calculating the overall business value.
If you take a closer look at the terminal value formula, you will see that the business earnings growth rate appears in the denominator. In fact, this equals the business capitalization rate. Note that the cap rate equals the difference between the company’s discount rate and earnings growth.
Common mistake – overstating the earnings growth rate
Business appraisers need to figure out how to accurately estimate this earnings growth number. Should you base in some way on your cash flows forecast? Or does the answer lie elsewhere?
A number of businesses, especially young companies, may experience periods of rapid earnings growth. If you base your long-term earnings growth estimate on this, you may come up with a number that exceeds the business discount rate.
Negative capitalization rate?
Mathematically this produces a negative capitalization rate. In economic terms, this means that the business cost of capital is below its long-term earnings growth prospects, an impossible scenario.
The net result is that the terminal value becomes a negative number and the discounted cash flow analysis breaks down. What this tells us is that the long-term earnings growth rate has been overestimated.
Short term earnings growth versus sustainable growth rate
In the short run, your business earnings may well grow rapidly. However, as the company matures a number of factors act to limit its growth prospects. New competitors enter the market exerting a downward pressure on the company’s profits. Market saturation demands that the firm look for additional income elsewhere. Products and services eventually need upgrading which calls for capital infusions further reducing the available cash flow from the business operations.
So where should you look for guidance in assessing the business long-term earnings growth? Consider a few possibilities:
- Look at the overall economic situation both regionally and nationally. Is your earnings growth expectation realistic against this background?
- Estimate the industry sector growth rates. Are your projections consistent with the industry peers’ performance?
- Carefully review your cash flow forecast. Do you anticipate some growth spurt to occur followed by a period of more stable earnings?
Remember that the key reason the terminal value is added to the discounted cash flow valuation is that you may have trouble coming up with a reliable earnings forecast too far into the future.
This uncertainty would call for a conservative estimation of the business profitability going forward. And it usually means a sensible earnings growth estimate and a more defensible business valuation result.