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Unformatted text preview: 1 LOOKING FORWARD: ESTIMATING GROWTH The value of a firm is the present value of expected future cash flows generated by the firm. The most critical input in valuation, especially for high growth firms, is the growth rate to use to forecast future revenues and earnings. In this chapter, you consider how best to estimate these growth rates for technology firms, especially those with low revenues and negative earnings. There are three basic ways of estimating growth for any firm. One is to look at the growth in a firms past earnings its historical growth rate. While this can be a useful input when valuing stable firms, there are both dangers and limitations in using this growth rate for high growth firms, especially technology firms. The historical growth rate can often not be estimated, and even if it can, it cannot be relied on as an estimate of expected future growth. The second is to trust the equity research analysts that follow the firm to come up with the right estimate of growth for the firm, and to use that growth rate in valuation. While technology firms are widely followed by analysts, the quality of growth estimates, especially over longer periods, is poor. Relying on these growth estimates in a valuation can lead to erroneous and inconsistent estimates of value. The third is to estimate the growth from a firms fundamentals. A firms growth ultimately is determined by how much is reinvested into new assets and the quality of these investments, with investments widely defined to include acquisitions, building up distribution channels or even expanding marketing capabilities. By estimating these inputs, you are, in a sense, estimating a firms fundamental growth rate. While the determinants of fundamental growth remain the same for all firms, estimating these inputs for technology firms can pose special challenges. Where, you might ask, are the subjective elements that go into estimating growth: the quality of management, changing market dynamics, the possibility that firms may change their business mixes? In a sense, they are everywhere. 2 When you estimate expected future margins and returns, any views that you might have about how a firm is likely to change in the future should find its way into these estimates. The Importance of Growth While growth is a critical component of value in all valuations, it represents a large portion of value at technology firms and almost all of the value at the new technology firms. In fact, this is the reason why many investors and private equity investors are attracted to them in the first place. Thus, growth is both the calling card and the primary determinant of value at technology firms. In this section, the value of a firm is presented as the sum of the values of its existing investments and its expected growth potential. You then look at a series of statistics that measure the importance of growth assets at technology firms....
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- Fall '11