growthorigins

growthorigins - 1 Growth and Value Past growth predicted...

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Unformatted text preview: 1 Growth and Value: Past growth, predicted growth and fundamental growth Aswath Damodaran Stern School of Business June 2008 2 Growth and Value: Past growth, predicted growth and fundamental growth A key input, when valuing businesses, is the expected growth rate in earnings and cash flows. Allowing for a higher growth rate in earnings usually translates into higher value for a firm. But why do some firms grow faster than others? In other words, where does growth come from? In this paper, we argue that growth is not an exogenous input subject to the whims and fancies of individual analysts, but has to be earned by firms. In particular, we trace earnings growth back to two forces: investment in new assets, also called sustainable growth, and improving efficiency on existing assets, which we term efficiency growth. We use this decomposition of growth to examine both historical growth rates in earnings across firms and the link between value and growth. We close the paper by noting that the relationship between growth and value is far more nuanced than most analysts assume, with some firms adding value as they grow, some staying in place and some destroying value. 3 Growth is a central input in the valuation of businesses. In discounted cash flow models, it is the driver of future cash flows and by extension the value of these cash flows. In relative valuation, it is often the justification that is offered for why we should pay higher multiples of earnings or book value for some firms than for others. Given its centrality in valuation, it is surprising how ad hoc the estimation of growth is in many valuations and how little we know about its history, origins and relationship to value. Growth as a Valuation Input We begin this paper by looking at how growth plays a role in both discounted cash flow valuation and relative valuation. In the former, it is an explicit input that is key to determining value. In the latter, it is more often a subjective component used to explain why some companies should trade at higher value (or multiples) than others. Discounted Cash flow Valuation In a discounted cash flow framework, the value of an asset or business is the present value of the expected cash flows generated by that asset (business) over time. When valuing a business, these expected cash flows are usually generated from estimated earnings in future periods, which, in turn, are determined by current earnings and the expected growth rate in these earnings. Thus, the value of a business is a function of the expected earnings growth rate, though, as we will see later in this paper, the relationship is neither as simple nor as obvious as it looks at first sight. DCF Valuation Approaches There are two ways in which we can approach discounted cash flow valuation....
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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growthorigins - 1 Growth and Value Past growth predicted...

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