How long with high growth last?

The question of how long a firm will be able to sustain high growth is perhaps one of the more difficult questions to answer in a valuation, but two points are worth making. One is that it is not a question of whether but when firms hit the stable growth wall. All firms ultimately become stable growth firms, in the best case, because high growth makes a firm larger and the firm’s size will eventually become a barrier to further high growth. In the worst case scenario, firms may not survive and will be liquidated. The second is that high growth in valuation, or at least high growth that creates value[1], comes from firms earning excess returns on their marginal investments. In other words, increased value comes from firms having a return on capital that is well in excess of the cost of capital (or a return on equity that exceeds the cost of equity). Thus, when you assume that a firm will experience high growth for the next 5 or 10 years, you are also implicitly assuming that it will earn excess returns (over and above the required return) during that period. In a competitive market, these excess returns will eventually draw in new competitors and the excess returns will disappear.

You should look at three factors when considering how long a firm will be able to maintain high growth.

1.           Size of the firm: Smaller firms are much more likely to earn excess returns and maintain these excess returns than otherwise similar larger firms. This is because they have more room to grow and a larger potential market. Small firms in large markets should have the potential for high growth (at least in revenues) over long periods. When looking at the size of the firm, you should look not only at its current market share, but also at the potential growth in the total market for its products or services. A firm may have a large market share of its current market, but it may be able to grow in spite of this because the entire market is growing rapidly

2.           Existing growth rate and excess returns: Momentum does matter, when it comes to projecting growth. Firms that have been reporting rapidly growing revenues are more likely to see revenues grow rapidly at least in the near future. Firms that are earnings high returns on capital and high excess returns in the current period are likely to sustain these excess returns for the next few years.

3.           Magnitude and Sustainability of Competitive Advantages: This is perhaps the most critical determinant of the length of the high growth period. If there are significant barriers to entry and sustainable competitive advantages, firms can maintain high growth for longer periods. If, on the other hand, there are no or minor barriers to entry or if the firm’s existing competitive advantages are fading, you should be far more conservative about allowing for long growth periods. The quality of existing management also influences growth. Some top managers[2] have the capacity to make the strategic choices that increase competitive advantages and create new ones.

The confluence of high growth and excess returns which is the source of value has led to the coining of the term “competitive advantage period” (CAP) to capture the joint effect. This term, first used by Michael Mahboussin at Credit Suisse First Boston, measures the period for which a firm can be expected to earn excess returns.  The value of such a firm can then be written as the sum of the capital invested today and the present value of the excess returns that the firm will earn over its life.  Since there are no excess returns after the competitive advantage period, there is no additional value added.

            In an inventive variant, analysts sometimes try to estimate how long the competitive advantage period will have to be to sustain a current market value, assuming that the current return on capital and cost of capital remain unchanged. The resulting market implied competitive advantage period  (MICAP) can then be either compared across firms in a sector or evaluated on a qualitative basis.

 

 



[1] Growth without excess returns will make a firm larger but not more valuable.

[2] Jack Welch at GE and Robert Goizueta at Coca Cola are good examples of CEOs who made a profound difference in the growth of their firms.