Barriers to entry and differential advantages • Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages . • The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain.
Aswath Damodaran 72 3. What else should change in stable growth? In stable growth, firms should have the characteristics of other stable growth firms. In particular, • The risk of the firm, as measured by beta and ratings, should reflect that of a stable growth firm. – Beta should move towards one – The cost of debt should reflect the safety of stable firms (BBB or higher) • The debt ratio of the firm might increase to reflect the larger and more stable earnings of these firms. – The debt ratio of the firm might moved to the optimal or an industry average – If the managers of the firm are deeply averse to debt, this may never happen • The return on capital generated on investments should move to sustainable levels, relative to both the sector and the company’s own cost of capital.
Aswath Damodaran 73 4. What excess returns will you generate in stable growth and why does it matter? Strange though this may seem, the terminal value is not as much a function of stable growth as it is a function of what you assume about excess returns in stable growth. The key connecting link is the reinvestment rate that you have in stable growth, which is a function of your return on capital: Reinvestment Rate = Stable growth rate/ Stable ROC The terminal value can be written in terms of ROC as follows: Terminal Value = EBIT n+1 (1-t) (1 – g/ ROC)/ (Cost of capital – g) In the scenario where you assume that a firm earns a return on capital equal to its cost of capital in stable growth, the terminal value will not change as the growth rate changes. If you assume that your firm will earn positive (negative) excess returns in perpetuity, the terminal value will increase (decrease) as the stable growth rate increases.
Aswath Damodaran 74 Stable Growth Assumptions: Tata Group Tata Chemicals Tata Steel Tata Motors TCS Beta High Growth 1.21 1.57 1.20 1.05 Stable Growth 1.00 1.20 1.00 1.00 Lambda High Growth 0.75 1.10 0.80 0.20 Stable Growth 0.75 1.10 0.80 0.20 Country Risk Premium High Growth 4.50% 4.50% 4.50% 4.50% Stable Growth 3.00% 3.00% 3.00% 3.00% Cost of equity High Growth 13.82% 17.02% 14.00% 10.63% Stable Growth 11.75% 13.70% 11.90% 10.10% Debt Ratio High Growth 30.48% 29.59% 25.30% 0.03% Stable Growth 30.48% 29.59% 25.30% 10% Cost of debt High Growth 10.00% 9.25% 12.25% 8.50% Stable Growth 8.00% 7.75% 9.00% 6.50% Cost of capital High Growth 11.62% 13.79% 12.50% 10.62% Stable Growth 9.78% 11.16% 10.39% 9.52% Reurn on capital High Growth 13.42% 11.81% 17.16% 40.63% Stable Growth 9.78% 11.16% 12.00% 15% Reinvestment Rate High Growth 56.50% 38.09% 70.00% 56.73% Stable Growth 51.14% 44.80% 41.67% 33.33% Expected growth rate High Growth 5.85% 5.11% 12.01% 23.05% Stable Growth 5% 5% 5% 5%
Aswath Damodaran 75 Terminal Value and Growth: Contrasts
Aswath Damodaran 76 V. Tying up Loose Ends For firm value to equity value per share
Aswath Damodaran 77 1. Value cash and other non-operating assets When you discount operating cash flows at the cost of capital, you have valued only the operating assets (that contribute to the operating income) of the firm.
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