When business valuation professionals select from the menu of appraisal techniques, the income approach is a popular choice. This technique derives value by converting anticipated economic benefits into their net present value. Long-term sustainable growth is a key ingredient.
Capitalization of Earnings Method
Here’s the recipe for valuing a business under the income approach, when the subject company’s earnings and risks have stabilized:
Value = [NCF x (1 + g)] / (k-g)
Where:
- NCF = net cash flow
- k = discount rate
- g = long-term sustainable growth rate
Also known as the capitalization of earnings method, this recipe projects future cash flows and divides them by a capitalization rate. The long-term growth rate factors into both the numerator and denominator of this equation.
Discounted Cash Flow Method
When cash flows and risk factors will vary over a discrete period, valuators may instead opt for the more complicated discounted cash flow (DCF) method. Here, cash flows are projected over a discrete period and then discounted to their net present value. At the end of the discrete period, cash flows are assumed to stabilize and a terminal (or residual) value is computed, typically using the capitalization of earnings method (above). The terminal value also must be discounted to present value, along with the cash flows expected over the discrete period.
In other words, the terminal value — which can often represent more than 50% of the total value of the business when using the DCF method — is where the long-term growth rate factors into this method.
Supporting Growth
The growth rate is made up of two factors:
1. Inflation. Economists have been predicting inflation for decades in The Livingston Survey, a publication of the Federal Reserve Bank of Philadelphia. In an inflationary environment, a company that’s not growing (but merely staying even) will generally grow at the rate of inflation.
2. Real Growth. Long-term sustainable growth rate can exceed inflation, depending on the relative strengths and risks associated with the subject company. Conversely, a distressed company might be unable to keep pace with inflation.
Valuation professionals consider external factors (such as changes in the regulatory environment or emergent technology) and internal factors (such as the company’s financial performance and the quality of its management team) when quantifying the long-term sustainable growth rate.
Small Changes in Growth, Big Changes in Value
Small changes in the growth rate can have a big impact on the value of a business. For example, an increase of the growth rate from 3% to 6% can result in a 33% increase in business value (or in the terminal value, if using the DCF method).
As this example shows, the selection of the long-term growth rate is important. Growth rates above or below inflation are frequently warranted. But they require detailed explanations in the valuator’s report to withstand external scrutiny and arrive at an accurate conclusion of value.