The income approach is a common choice when appraisers are selecting appraisal techniques. Value is found with this technique by converting future economic benefits into their net present value. Long-term sustainable growth is a key part of this.
Capitalization of Earnings Method
When valuing a business under the income approach, the following formula is used, assuming the company’s earnings and risks are stabilized.
Value = [NCF x (1 + g)] / (k-g), with NCF equaling net cash flow, k equaling discount rate, and g equaling long-term sustainable growth rate.
Also known as the capitalization of earnings method, this formula 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
If a company’s cash flows and risk factors vary over a specified period of time, valuators may instead choose 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 value” is computed, typically using the capitalization of earnings method. 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 percent of the total value of the business when using the DCF method, is where the long-term growth rate factors into this method.
The growth rate is made up of two factors:
- 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 is merely staying even and not growing will still exhibit growth at the rate of inflation.
- Real Growth.Depending on the strengths and risks associated with the business, it is possible for long-term sustainable growth rate to exceed inflation, just as a distressed company may be unable to keep pace with inflation.
Valuation professionals consider both external factors, like changes in emergent technology, and internal factors, like the company’s financial performance and the quality of its management team, when figuring out 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 percent to 6 percent could cause a 33 percent increase in business value (or in the terminal value, if using the DCF method).
Obviously, the selection of the long-term growth rate is important. Growth rates above or below inflation are often used, but require detailed explanations in the appraiser’s report to withstand external scrutiny and arrive at an accurate conclusion of value.
For more information about long-term growth rate and its effect on valuations, give Filler & Associates a call.