Length of Extraordinary Growth Period

The question of how long a firm will be able to sustain high growth is perhaps one of the more difficult questions to answer in a valuation, but two points are worth making. One is that it is not a question of whether but when firms hit the stable growth wall. All firms ultimately become stable growth firms, in the best case, because high growth makes a firm larger and the firm's size will eventually become a barrier to further high growth. In the worst-case scenario, firms may not survive and will be liquidated. The second is that high growth in valuation, or at least high growth that creates value1, comes from firms earning excess returns on their marginal investments. In other words, increased value comes from firms having a return on capital that is well in excess of the cost of capital (or a return on equity that exceeds the cost of equity). Thus, when you assume that a firm will experience high growth for the next 5 or 10 years, you are also implicitly assuming that it will earn excess returns (over and above the required return) during that period. In a competitive market, these excess returns will eventually draw in new competitors and the excess returns will disappear.

We should look at three factors when considering how long a firm will be able to maintain high growth.

1. Size of the firm: Smaller firms are much more likely to earn excess returns and maintain these excess returns than otherwise similar larger firms. This is because

1 Growth without excess returns will make a firm larger but not more valuable.

they have more room to grow and a larger potential market. Small firms in large markets should have the potential for high growth (at least in revenues) over long periods. When looking at the size of the firm, you should look not only at its current market share, but also at the potential growth in the total market for its products or services. A firm may have a large market share of its current market, but it may be able to grow in spite of this because the entire market is growing rapidly

2. Existing growth rate and excess returns: Momentum does matter, when it comes to projecting growth. Firms that have been reporting rapidly growing revenues are more likely to see revenues grow rapidly at least in the near future. Firms that are earnings high returns on capital and high excess returns in the current period are likely to sustain these excess returns for the next few years.

3. Magnitude and Sustainability of Competitive Advantages: This is perhaps the most critical determinant of the length of the high growth period. If there are significant barriers to entry and sustainable competitive advantages, firms can maintain high growth for longer periods. If, on the other hand, there are no or minor barriers to entry or if the firm's existing competitive advantages are fading, you should be far more conservative about allowing for long growth periods. The quality of existing management also influences growth. Some top managers2 have the capacity to make the strategic choices that increase competitive advantages and create new ones.

Illustration 4.1: Length of High Growth Period

To illustrate the process of estimating the length of the high growth period, we will consider all of the companies that we will be valuing in the next two chapters and make subjective judgments about how long each one will be able to maintain high

growth.

Company

Competitive Advantage

Potential threats

Length of Growth period

J.P. Morgan Chase (Current ROE= 11.16%)

Size of firm and range of financial services.

Little pricing power; Out maneuvered by smaller and nimbler competitors.

No high growth period.

2 Jack Welch at GE and Robert Goizueta at Coca Cola are good examples of CEOs who made a profound difference in the growth of their firms, which were perceived as mature firms when they took the reins.

Goldman Sachs (Current ROE= 18.49%)

Investment banking brand name. Market know-how and trading expertise.

Markets in the US and Europe are saturated and are volatile.

High growth period of 5 years.

Canara Bank (Current ROE = 23.22%)

Significant presence in a high growth market (India) with restrictions on new entrants.

Easing of bank entry allowing foreign banks to compete in market.

High growth period of 10 years.

Exxon Mobil (Current ROE = 19.73%)

Economies of scale and ownership of undeveloped oil reserves.

Oil is a non-renewable resource and alternative energy sources are becoming more feasible.

No high growth period.

Toyota Motors (Current ROE = 10.18%)

Healthiest and most efficient company in a troubled sector. Leader in energy efficient hybrids.

Overall growth in auto business slowing and competition increasing from Chinese and Indian automakers.

High growth period of 5 years.

Tsingtao Breweries (Current ROE= 8.06%)

Strong brand name in Asia, where beer consumption is growing rapidly.

Established breweries in the US and Europe and other breweries in Asia competing for same market.

High growth period of 10 years.

Nintendo (Current ROC = 8.54%)

Early entrant with proprietary technology in gaming business.

Intense competition from larger competitors with own proprietary technologies (Sony and Microsoft)

No high growth period.

Target

(Current ROC= 9.63%)

"Cool" retailer with good management.

In a business that is subject to fads; Market in the US can become saturated.

High growth period of 5 years.

Embraer

(Current ROC= 16.93%)

Strong presence in small corporate and executive jet market. Cost advantages over developed market competitors.

Developed market competitors like Boeing and Airbus trying to move production to cheaper locales.

High growth period of 10 years.

Sirius Radio (Current ROC = Negative)

Pioneer in high growth satellite radio

Competition is likely to be intense not

High growth period of 10

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