Business Valuation Review Volume 41: Issue 3

Sustainable growth is one of the key inputs in the income approach. I have seen wide variation in practice over time with respect to selection of a sustainable growth rate ranging from long-term targets for inflation, expected industry growth rates, T-Bond yields and expected growth of the Gross Domestic Product. This list is clearly not exhaustive; I have seen many different variations with high growth companies. Shannon Pratt illustrated the significance of the long-term growth rate in the following passage from Valuing a Business:

“Changes in the growth rate forecasted, sometimes seemingly small, can result in striking changes.

When using the income approach to value a business, selecting a sustainable long-term growth rate is a necessary input into the valuation model, one that can have a material effect on the value of the business. The business valuation literature has provided little guidance for estimating and understanding sustainable long-term growth rates. Apart from relying on macroeconomic indicators and historical industry averages, appraisers have few options for selecting sustainable long-term growth rates and are often relegated to making arbitrary assumptions. The objective of this article is to examine the accuracy of using historical industry average growth rates, historical average gross domestic product growth rates, and expected inflation as sustainable long-term growth rates. The accuracy of the forecasts was examined vis-à-vis actual growth rates for twenty-one selected industries from 1991 to 2021 for the purpose of selecting the most accurate forecasting method. The forecasts premised on expected inflation proved to be the most accurate. In light of the results, the notion that expected inflation may be the best estimate of sustainable long-term growth was explored.

Long-run growth rates play a central role in all discounted cash flow models. This is true whether the goal is to estimate the value of a company or to estimate the cost of equity. It is well recognized as a matter of mathematics—although not always incorporated into practice—that the long-run expected growth rate cannot exceed the growth rate of the aggregate economy. What is less widely appreciated is that as an empirical matter the long-run growth rates for existing companies (that is, companies that are being appraised or whose cost of equity is being estimated) are almost certain to be less than the growth rate of the aggregate economy. Based on analysis of net dilution from 1926 to 2017, a more reasonable approximation for the average long-run growth of existing companies is approximately two percentage points less than the expected nominal growth rate of GDP.

This article follows the authors' article in Business Valuation Review (November 2020) that explored typical errors when capitalizing cash flows in the terminal period of the Discounted Cash Flow Method. Since investments related to intangible assets are often expensed immediately through the income statement under generally accepted accounting principles, the article demonstrated that without significant adjustment, the value driver formula would likely overstate the net reinvestment into fixed assets and working capital when calculating the terminal value and understate the value of the company. This article provides examples of the types of adjustments necessary to calculate an economically internally consistent terminal value when applying the value driver formula to a subject company that derives significant value from intangible assets. This article also provides an example analysis using a real-world transaction to illustrate the necessary adjustments to expensed investments (e.g., research and development) when applying the value driver formula to Oracle's acquisition of NetSuite.

From the Editor

Is Expected Inflation the Best Long-term Sustainable Growth Rate?

Long-run Growth Rates in Discounted Cash Flow Models

Adjusting Tech Company Financial Statements When Applying the Value Driver Formula

Unlocking the Value of ESG: Report from the International Valuation Standard Council

From the Chair

Volume 41, No. 3 — Complete Issue

From the Editor

Customer Concentration: Good, Bad, or Ugly?

From the Chair

Delaware Valuation Decisions, 2021 to 2024

Volume 44, No. 1 — Complete Issue