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 firmÕs 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 firmÕs 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
Òcompetitive advantage periodÓ (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.