Demystifying Valuation: A Comprehensive Guide to the Discounted Cash Flow (DCF) Approach

12th edition

Introduction

This edition explores the key differences between high-growth and stable-growth firms. These differences are analyzed based on factors such as market exposure, return on capital, excess returns, and the debt content in capital structures, offering valuable insights into the financial strategies employed at different growth stages.

What are the parameters by which we can differentiate a high-growth firm from a stable-growth firm?

Three key parameters allow us to differentiate between a high-growth firm and a stable-growth firm:

1. Exposure to Market Risk: High-growth firms are typically more exposed to market risks due to their reliance on rapid expansion, innovation, or market dominance strategies. In contrast, stable growth firms have a more predictable and mature business model, which leads to lower exposure to market fluctuations and risks.
2. Return on Capital and Excess Return: High-growth firms usually have a higher Return on Capital (ROC), often exceeding the cost of capital, resulting in positive excess returns. This indicates that high-growth firms can generate returns greater than the required rate of return. Conversely, stable growth firms typically have an ROC that aligns more closely with the cost of capital. This leads to limited or no excess returns, reflecting a more mature and stable phase of business operations.
3. Debt Content in Capital Structure: High-growth firms tend to rely less on debt in their capital structure due to the risks associated with high leverage during periods of rapid growth and market uncertainty. Stable growth firms, however, often exhibit a higher proportion of debt in their capital structure, as they have more predictable cash flows and are better positioned to manage debt repayment.

In simple terms, high-growth firms have more exposure to market risks, achieve higher returns on capital, and generate excess returns, while maintaining lower debt levels. On the other hand, stable growth firms have lower market risk, returns that are more closely aligned with the cost of capital, and rely more on debt in their capital structure.

How do you distinguish a ‘high growth firm’ from a ‘stable growth firm’ based on market exposure?

Empirical evidence indicates that high-growth firms are generally more exposed to market risk than their stable growth counterparts. A common metric for measuring a firm's exposure to market risk is its beta, which reflects the sensitivity of its stock returns to overall market movements.

According to market conventions, a rule of thumb is that if a firm's beta exceeds 1.80, it is typically considered a high-growth firm. A beta greater than one indicates that the firm’s stock is more volatile and exposed to market fluctuations. In contrast, firms with lower beta values are less volatile and are usually considered stable growth firms.

Example: If a firm's beta is 2.0, this suggests that its stock price is expected to move twice as much as the market. For instance, if the market increases by 10%, the firm's stock price may increase by 20%. Such volatility is characteristic of a high-growth firm. On the other hand, a stable growth firm with a beta of 1.0 would be expected to move in line with the market, showing more predictable and less risky returns.

Generally, firms with higher betas, typically above 1.80, are more exposed to market risk and are classified as high-growth firms. In contrast, stable growth firms exhibit lower betas, reflecting lower market risk and more stable performance.

How do you distinguish a ‘high growth firm’ from a ‘stable growth firm’ based on its level of ‘return on capital’ and ‘excess return’?

High-growth firms generally exhibit a higher Return on Capital (ROC) and generate excess returns than stable-growth firms. Excess return refers to the difference between a firm's ROC and its cost of capital, indicating whether the firm can generate returns above the required rate of return.

By comparing a firm's ROC with the industry average ROC, we can gain valuable insights into the firm’s growth rate. Firms with an ROC significantly above the industry average are more likely to be in the high growth phase, while firms with an ROC closer to the industry average are likely in the stable growth phase.

Additionally, statistical techniques such as regression analysis can be used to assess further whether a firm is achieving high growth. By analyzing trends in ROC and comparing them to industry benchmarks, we can determine if a firm is outperforming or converging toward the industry standard.

Theoretical Assumption: In a stable growth firm, it can be assumed that the excess return will converge towards zero, meaning the firm's ROC will eventually align with its cost of capital and the industry average. This indicates that the firm has reached a point of equilibrium where it is no longer generating returns significantly above its required rate of return.

Example: Suppose a high growth firm has a Return on Capital of 18%, while the average ROC in the industry is 12%. The firm is generating an excess return of 6% (18% - 12%). In contrast, a stable growth firm might have a ROC of 12%, exactly matching the industry average, implying that it no longer earns excess returns.

In a nutshell, high-growth firms can be distinguished by their higher ROC and significant excess returns compared to stable-growth firms, which tend to generate returns closer to the industry average. Statistical techniques and comparative analysis can help quantify and evaluate these differences.

How tenable is the assumption of ‘zero excess return’ in the case of stable growth firms?

The assumption that a firm's assets will immediately cease to earn excess returns upon entering the stable growth period is only partially realistic. Assets maintain their ability to generate returns above the required rate simply due to the firm's transition into stable growth. Instead, it is more reasonable to assume that, over time, the entire industry tends towards zero excess returns in the long run, and individual firms gradually move towards the industry average.

This implies that while a stable growth firm may still generate some excess returns for a period, those returns will likely diminish as its competitive advantages erode, market competition intensifies, and its performance aligns more closely with its industry peers. The convergence towards zero excess return happens gradually as the firm’s Return on Capital (ROC) aligns with the cost of capital and the industry average over time.

Example: Consider a firm with a Return on Capital of 15% and a cost of capital of 10%, earning an excess return of 5%. As the firm matures and enters the stable growth phase, competitive forces may gradually reduce its excess return. Over time, the firm's ROC may decline to 12%, while the cost of capital remains 10%, resulting in a reduced excess return of 2%. Eventually, the firm’s ROC may converge to 10%, matching its cost of capital, at which point the excess return would be zero.

In a nutshell, assuming that zero excess returns apply to the industry in the long run rather than immediately applying to individual firms as they enter the stable growth phase is more reasonable. Firms tend to converge towards industry averages over time rather than abruptly losing their excess return capacity.

How do you distinguish a ‘high growth firm’ from a ‘stable growth firm’ based on the proportion of debt in the capital structure?

High-growth firms tend to use less debt in their capital structure compared to stable-growth firms. This is primarily because high-growth firms typically have lower liquidity as they require significant funds for expansion activities, product development, and market penetration. Consequently, high-growth firms may avoid high debt levels to prevent liquidity constraints and financial risk during their rapid expansion phase.

In contrast, stable growth firms generally have more predictable cash flows and greater liquidity, which allows them to manage debt obligations more effectively. As a result, stable growth firms often prefer to incorporate more debt into their capital structure, leveraging their steady cash flows to take advantage of lower-cost capital through debt financing.

Example: A high-growth firm in the technology sector may have a debt-to-equity ratio of 0.3, reflecting its cautious use of debt to avoid financial strain during its expansion. In contrast, a stable growth firm in the utilities sector, with predictable and stable revenue, may have a debt-to-equity ratio of 1.2, indicating a higher reliance on debt to finance its operations due to its ability to meet debt obligations without jeopardizing financial stability.

Thus, the firm’s growth stage influences its debt ratio. High-growth firms minimize debt usage due to liquidity constraints, while stable-growth firms are more comfortable with higher debt content as they have sufficient funds to meet debt obligations.

In a nutshell, high-growth firms typically have lower debt content in their capital structure. In contrast, stable-growth firms tend to incorporate more debt due to their greater liquidity and stable cash flows, enabling them to manage higher debt levels efficiently.

Conclusion

It is important to understand how companies transition from high-growth to stable-growth stages in order to assess their financial health and risk profiles. By examining market exposure, return on capital, and debt ratios, investors and analysts can make better-informed decisions about a company's long-term sustainability and growth potential.