Barriers to entry and differential advantages High growth comes from high returns, that, in turn comes from barriers to entry and differential advantages. The question is how long growth will last and how high it will be that can be reframed as; what are the barriers to entry; how long barriers to entry will stay up and how strong will they remain. Growth patterns depend on size, current growth and barriers to entry
25 Stable Growth and Fundamentals The growth rate of a firm is driven by its fundamentals – how much it reinvests and how high project returns are. As growth approach stability, the firm should be given the characteristics of a stable growth firm. Model DDM FCFE / FCFF High Growth firms usually… 1. Pay no or low dividends 2. Have high risk 3. Earn high ROC Stable Growth firms usually… 1. Pay high dividends 2. Have average risk 3. Earn ROC closer to WACC 1. Have high capex 2. Have high risk 3. Earn high ROC 4. Have low leverage 1. Have lower net capex 2. Have average risk 3. Earn ROC closer to WACC 4. Have leverage closer to industry average
Simple Examples General Question: 26
27 DDM: Estimating Stable Growth Payout Assume that DBS Bank has ROE = 15.79%, retention ratio = 53.88% and EPS growth = 8.51% Assume that DBS Bank will be in stable growth in 5 years. At that point assume that ROE = 15% and it will grow at a normal rate of 5%. What is the expected payout ratio under stable growth: Stable growth payout ratio = 1 – g/ROE = 1 – 0.05/0.15 = 66.67% Note: g = b x ROE or b = g/ROE where payout = 1-b Sustainable growth equation: ROE = E 1 /BV 0 = E 1 /Sales 1 x Sales 1 /Total Asset 0 x Total Assets 0 /Equity 0 g = b x ROE = P x R x A x T (see assignment 2 …)
28 FCFF: Estimating Reinvestment Rate The soundest way of estimating reinvestment rates in stable growth is to relate them to expected growth and return on capital: Reinvestment rate = Growth in Operating Income / ROC For example, Apple is expected to be in stable growth in 10 years from now, growing at 5% a year and earning a return on capital of 16.52% (which is the industry average). The reinvestment rate in year 10 can be estimated as follows: Reinvestment rate = 5% / 16.52% = 30.27% To grow, a firm must reinvest
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