In Practice What Is A Stable Growth Rate

Determining when your firm will be in stable growth is difficult to do without first defining what we mean by a stable growth rate. There are two insights to keep in mind when estimating a "stable" growth rate. First, since the growth rate in the firm's cashflows is expected to last forever, the firm's other measures of performance (including revenues, earnings and reinvestment) can be expected to grow at the same rate. Consider the long-term consequences of a firm whose earnings grow 6% a year forever, while its dividends grow at 8%. Over time, the dividends will exceed earnings. Similarly, if a firm's earnings grow at a faster rate than its dividends in the long term, the payout ratio will converge towards zero, which is also not a steady state. The second issue relates to what growth rate is reasonable as a 'stable' growth rate. Again, the assumption that this growth rate will last forever establishes rigorous constraints on "reasonableness". A firm cannot in the long term grow at a rate significantly greater than the growth rate in the economy in which it operates. Thus, a firm that grows at 8% forever in an economy growing at 4% will eventually become larger than the economy. In practical terms, the stable growth rate cannot be larger than the nominal (real) growth rate in the economy in which the firm operates, if the valuation is done in nominal (real) terms.

Can a stable growth rate be much lower than the growth rate in the economy? There are no logical or mathematical limits on the downside. Firms that have stable growth rates much lower than the growth rate in the economy will become smaller in proportion to the economy over time. Since there is no economic basis for arguing that this cannot happen, there is no reason to prevent analysts from using a stable growth rate much lower than the nominal growth rate in the economy. In fact, the stable growth rate can be a negative number. Using a negative stable growth rate will ensure that your firm peaks in your last year of high growth and becomes smaller each year after that.

There is one rule of thumb that works well in setting a cap on the stable growth rate. The stable growth rate should generally not exceed the riskfree rate used in a valuation. Why should the two be related? The riskfree rate can be decomposed into an expected inflation rate and an expected real interest rate. If we assume that the real growth rate of an economy will be equal to the real interest rate in the long term, the riskfree rate becomes a proxy for the nominal growth rate in the economy.

Money Mogul

Money Mogul

Get All The Support And Guidance You Need To Be A Success At Being A Money Mogul. This Book Is One Of The Most Valuable Resources In The World When It Comes To How to Maintain the Pledge to Fix Your Finances from Your New Year’s Resolution.

Get My Free Ebook

Post a comment