(Cost of Capital n - gn) In the special case where ROC is equal to the cost of capital, this estimate simplifies to become the following:

Terminal Value


Thus, in every discounted cash flow valuation, there are two critical assumptions we need to make on stable growth. The first relates to when the firm that we are valuing will become a stable growth firm, if it is not one already. The second relates to what the characteristics of the firm will be in stable growth, in terms of return on capital and cost of capital. We examined the first question earlier in this chapter when we looked at the dividend discount model. Let us consider the second question now.

As firms move from high growth to stable growth, we need to give them the characteristics of stable growth firms. A firm in stable growth will be different from that same firm in high growth on a number of dimensions. For instance,

• As we noted with equity valuation models, high growth firms tend to be more exposed to market risk (and have higher betas) than stable growth firms. Thus, although it might be reasonable to assume a beta of 1.8 in high growth, it is important that the beta be lowered, if not to one, at least toward one in stable growth22.

• High growth firms tend to have high returns on capital and earn excess returns. In stable growth, it becomes much more difficult to sustain excess returns. There are some who believe that the only assumption sustainable in stable growth is a zero excess return assumption; the return on capital is set equal to the cost of capital. While we agree, in principle, with this view, it is difficult in practice to assume that all investments, including those in existing assets, will suddenly lose the capacity to earn excess returns. Since it is possible for entire industries to earn excess returns over long periods, we believe that assuming a firm's return on capital will move towards its industry average yields more reasonable estimates of value.

• Finally, high growth firms tend to use less debt than stable growth firms. As firms mature, their debt capacity increases. The question whether the debt ratio for a firm should be moved towards its optimal cannot be answered without looking at the incumbent managers' power, relative to their stockholders, and their views about debt. If managers are willing to change their debt ratios, and stockholders retain some power, it is reasonable to assume that the debt ratio will move to the optimal level in stable growth; if not, it is safer to leave the debt ratio at existing levels.

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