Most people obsess about the growth when analysing a company. This obsession is mostly justified as growth is a critical parameter while assessing the valuation of the company. However, there are many a times when the growth of a company DOES NOT make any difference to the valuation.
This happens when the Return on Capital of a business is equal to its Cost of Capital and in such a scenario no matter what the growth rate is, the valuation will not change. This is applicable for both mature companies as well as ‘fast growing’ companies as shown below.
Let us assume Company A is a mature company in a mature business. In such a case the growth, if any, will be equal to the growth rate of the industry/economy. A valuation of such a business is done using the same formula that is commonly used to determine Terminal Value in a DCF calculation:
FAST GROWING COMPANY
Let us assume that Company B is a fast growing company that still has a ‘high growth’ period of 5 years and thereafter its growth rate will return to that of a mature company. The same principle used above can also be used here. However, the retention ratio, instead of being of being constant every year (in case of the mature company), will change every year in this case.
DOWNLOAD the Excel file for utilizing this concept from my BLOG. In this excel file you can change the growth rates for the above scenarios and see for yourself the effect on the valuation. Give it a try!
So the next time you obsess about forecasting the growth of a company, first see whether the Return on Capital of that company is above the Cost of Capital and also whether such excess return can be sustained even in the future. If not, save yourself the time and value the company using the formula shown in red colour above.
If want to know more about calculating Return on capital then see my earlier post here Return on invested capital (roic): one ratio to measure it all