The Stable Growth Rate

Of all the inputs into a discounted cash flow valuation model, none can affect the value more than the stable growth rate. Part of the reason for it is that small changes in the stable growth rate can change the terminal value significantly and the effect gets larger as the growth rate approaches the discount rate used in the estimation. Not surprisingly, analysts often use it to alter the valuation to reflect their biases.

The fact that a stable growth rate is constant forever, however, puts strong constraints on how high it can be. Since no firm can grow forever at a rate higher than the growth rate of the economy in which it operates, the constant growth rate cannot be greater than the overall growth rate of the economy. In making a judgment on what the limits on stable growth rate are, we have to consider the following questions.

1. Is the company constrained to operate as a domestic company or does it operate (or have the capacity) to operate multi-nationally? If a firm is a purely domestic company, either because of internal constraints (such as those imposed by management) or external (such as those imposed by a government), the growth rate in the domestic economy will be the limiting value. If the company is a multi-national or has aspirations to be one, the growth rate in the global economy (or at least those parts of the globe that the firm operates in) will be the limiting value. Note that the difference will be small for a U.S. firm, since the U.S economy still represents a large portion of the world economy. It may, however, mean that you could use a stable growth rate that is slightly higher (say 1/2 to 1%) for a Coca Cola than a Consolidated Edison.
2. Is the valuation being done in nominal or real terms? If the valuation is a nominal valuation, the stable growth rate should also be a nominal growth rate, i.e. include an expected inflation component. If the valuation is a real valuation, the stable growth rate will be constrained to be lower. Again, using Coca Cola as an example, the stable growth rate can be as high as 5.5% if the valuation is done in nominal U.S. dollars but only 3% if the valuation is done in real dollars.
3. What currency is being used to estimate cash flows and discount rates in the valuation? The limits on stable growth will vary depending upon what currency is used in the valuation. If a high-inflation currency is used to estimate cash flows and discount rates, the limits on stable growth will be much higher, since the expected inflation rate is added on to real growth. If a low-inflation currency is used to estimate cash flows, the limits on stable growth will be much lower. For instance, the stable growth rate that would be used to value Titan Cements, the Greek cement company, will be much higher if the valuation is done in drachmas than in euros.

While the stable growth rate cannot exceed the growth rate of the economy in which a firm operates, it can be lower. There is nothing that prevents us from assuming that mature firms will become a smaller part of the economy and it may, in fact, be the more reasonable assumption to make. Note that the growth rate of an economy reflects the contributions of both young, higher-growth firms and mature, stable growth firms. If the former grow at a rate much higher than the growth rate of the economy, the latter have to grow at a rate that is lower.

Setting the stable growth rate to be less than or equal to the growth rate of the economy is not only the consistent thing to do but it also ensures that the growth rate will be less than the discount rate. This is because of the relationship between the riskless rate that goes into the discount rate and the growth rate of the economy. Note that the riskless rate can be written as:

Nominal riskless rate = Real riskless rate + Expected inflation rate

In the long term, the real riskless rate will converge on the real growth rate of the economy and the nominal riskless rate will approach the nominal growth rate of the economy. In fact, a simple rule of thumb on the stable growth rate is that it should not exceed the riskless rate used in the valuation.

Can the stable growth rate be negative? There is no reason why not since the terminal value can still be estimated. For instance, a firm with $100 million in after-tax cash flows growing at –5% a year forever and a cost of capital of 10% has a value of:

Value of firm =

Intuitively, though, what does a negative growth rate imply? It essentially allows a firm to partially liquidate itself each year until it just about disappears. Thus, it is an intermediate choice between complete liquidation and the going concern that gets larger each year forever.

This may be the right choice to make when valuing firms in industries that are being phased out because of technological advances (such as the manufacturers of typewriters with the advent of the personal computer) or where an external and critical customer is scaling back purchases for the long term (as was the case with defense contractors after the end of the cold war).