As yous peruse discounted cash stream valuations, it is hitting how infrequently yous run across projections of negative growth into the future, fifty-fifty for companies where the tendency lines inwards revenues in addition to earnings accept been anything but positive. Furthermore, yous almost never run across a terminal value calculation, where the analyst assumes a negative growth charge per unit of measurement inwards perpetuity. In fact, when yous select upwards the possibility, the outset reaction that yous larn is that it is impossible to gauge terminal value amongst a negative growth rate. In this post, I volition introduce evidence that negative growth is neither uncommon nor unnatural in addition to that the best course, from a value perspective, for around firms is to shrink rather than grow.
The belief that most firms accept positive growth over fourth dimension is mayhap nurtured yesteryear the belief that it is unnatural for firms to accept negative growth in addition to that spell companies may accept a yr or 2 of negative growth, they bounce dorsum to positive growth sooner rather than later. To evaluate whether this belief has a soil inwards fact, I looked at compounded annual growth charge per unit of measurement (CAGR) inwards revenues inwards the most recent calendar yr (2015), the concluding 5 calendar years (2011-2015)and the concluding 10 calendar years (2006-2015) for both US in addition to global companies in addition to computed the percent of all companies (my sample size is 46,814 companies) that accept had negative growth over each of those fourth dimension periods:
| Region | Number of firms | % amongst negative revenue growth inwards 2015 | % amongst negative CAGR inwards revenues: 2011-2015 | % amongst negative CAGR inwards revenues: 2006-2015 |
|---|---|---|---|---|
Australia, NZ in addition to Canada | 5014 | 41.44% | 36.73% | 28.20% |
Developed Europe | 7082 | 33.42% | 30.03% | 24.25% |
Emerging Markets | 21196 | 43.06% | 29.35% | 21.50% |
Japan | 3698 | 33.41% | 20.76% | 31.80% |
United States | 9823 | 39.69% | 26.76% | 28.10% |
Grand Total | 46814 | 39.86% | 28.64% | 24.69% |
| Industry Grouping | Number of firms | % Negative inwards 2015 | % amongst Negative CAGR from 2011-2015 | % amongst Negative CAGR from 20106-2015 |
|---|---|---|---|---|
Publshing & Newspapers | 346 | 53.77% | 48.44% | 45.69% |
Computers/Peripherals | 327 | 43.30% | 42.12% | 45.65% |
Electronics (Consumer & Office) | 152 | 43.70% | 47.11% | 44.44% |
Homebuilding | 164 | 31.51% | 22.69% | 35.87% |
Oil/Gas (Production in addition to Exploration) | 959 | 79.22% | 43.75% | 35.40% |
Food Wholesalers | 126 | 37.00% | 30.59% | 33.33% |
Office Equipment & Services | 160 | 40.58% | 32.54% | 33.33% |
Real Estate (General/Diversified) | 418 | 41.33% | 32.72% | 32.52% |
Telecom. Equipment | 473 | 43.00% | 37.36% | 32.43% |
Steel | 757 | 73.23% | 50.65% | 32.08% |
Negative Growth Rates: Influenza A virus subtype H5N1 Corporate Life Cycle Perspective
One framework that I honor useful for agreement both corporate finance in addition to valuation issues is the corporate life cycle, where I draw a company’s life from nativity (as a start-up) to reject in addition to connect it to expectations close revenue growth in addition to lucre margins:
If yous purchase into this notion of a life cycle, yous tin already run across that valuation, at to the lowest degree equally taught inwards classes/books in addition to practiced, is non inwards keeping amongst the concept. After all, if yous apply a positive growth charge per unit of measurement inwards perpetuity to every theatre that yous value, the life wheel that is to a greater extent than inwards keeping amongst this persuasion of the globe is the following:
The occupation amongst this life wheel perspective is that the global marketplace position identify is non large plenty to adjust these ever-expanding behemoths. It follows, therefore, that in that location accept to last companies (and a pregnant number at that) where the hereafter holds shrinkage rather than growth. Fitting this perspective dorsum into the corporate life cycle, yous should last using a negative growth charge per unit of measurement inwards revenues in addition to mayhap declining margins to reach amongst those shrinking revenues inwards your valuation, if your companionship is already inwards decline. If yous are valuing a companionship that is mature correct straight off (with positive but rattling depression growth) but the overall marketplace position is stagnant or starting to decline, yous should last opened upwards to the possibility that growth could larn negative at the terminate of your forecast horizon.
There is an extension of the corporate life wheel that may also accept implications for valuation. In an before post, I noted that tech companies historic catamenia inwards Canis familiaris years in addition to often accept compressed life cycles, growing faster, reaping benefits for shorter fourth dimension periods in addition to declining to a greater extent than precipitously than non-tech companies. When valuing tech companies, it may behoove us to reverberate these characteristics inwards shorter (and to a greater extent than exuberant) growth periods, fewer years of stable growth in addition to terminal growth periods amongst negative growth rates.
There is an extension of the corporate life wheel that may also accept implications for valuation. In an before post, I noted that tech companies historic catamenia inwards Canis familiaris years in addition to often accept compressed life cycles, growing faster, reaping benefits for shorter fourth dimension periods in addition to declining to a greater extent than precipitously than non-tech companies. When valuing tech companies, it may behoove us to reverberate these characteristics inwards shorter (and to a greater extent than exuberant) growth periods, fewer years of stable growth in addition to terminal growth periods amongst negative growth rates.
Negative Growth Rates: The Mechanics
As I noted inwards my concluding post, the growth charge per unit of measurement inwards perpetuity cannot reach the growth charge per unit of measurement of the economic scheme but it tin last lower in addition to that lower number tin last negative. It is alone possible that i time yous larn to your terminal year, that your cash flows accept peaked in addition to volition driblet 2% a yr inwards perpetuity thereafter. Mathematically, the perpetual growth model nevertheless holds:
If yous produce assume negative growth, though, yous accept to examine whether equally the theatre shrinks, it volition last able to divest assets in addition to collect cash. If the answer is no, the final result of negative growth is unambiguously negative in addition to the terminal value volition reject equally growth gets to a greater extent than negative. If the answer is yes, the final result of negative growth inwards value volition depend upon how much yous volition larn from divesting assets.
To illustrate, consider the instance of the theatre amongst $100 i G k inwards expected after-tax operating income adjacent year, that is inwards perpetual growth in addition to let’s assume a perpetual growth charge per unit of measurement of -5% a yr forever. If yous assume that equally the theatre shrinks, in that location volition last no cash flows from selling or liquidating assets, the terminal value amongst a 10% terms of working capital alphabetic quality is:
To illustrate, consider the instance of the theatre amongst $100 i G k inwards expected after-tax operating income adjacent year, that is inwards perpetual growth in addition to let’s assume a perpetual growth charge per unit of measurement of -5% a yr forever. If yous assume that equally the theatre shrinks, in that location volition last no cash flows from selling or liquidating assets, the terminal value amongst a 10% terms of working capital alphabetic quality is:
Terminal value = $100/ (.10-(-.05)) = $666.67
If yous assume that in that location are assets that are beingness liquidated equally the theatre shrinks, yous accept to gauge the furnish on working capital alphabetic quality on these assets in addition to compute a reinvestment rate. If the assets that yous are liquidating, for instance, accept a 7.5% furnish on invested capital, the reinvestment charge per unit of measurement volition last -66.67%.
Reinvestment charge per unit of measurement = -5%/7.5% = 66.67%
If yous are puzzled yesteryear a negative reinvestment rate, it equally the cash inflow that yous are generating from property sales, in addition to your terminal value volition in addition to so be:
Terminal value = $100 (1-(-0.6667))/ (.10 – (-.05)) = $1,111.33
Put simply, the same dominion that governs whether the terminal value volition increase if yous increase the growth rate, i.e., whether the furnish on working capital alphabetic quality is greater than the terms of capital, plant inwards contrary when yous accept negative growth. As long equally yous tin larn to a greater extent than for divesting assets than equally continuing investments (present value of cash flows), liquidating them volition increase your terminal value.
Our unwillingness to consider using negative growth inwards valuation has turned the game over to growth advocates. Not surprisingly, in that location are many inwards academia in addition to practise who debate that the essence of practiced administration is to grow businesses in addition to that the terminate game for companies is corporate sustainability. That's nonsense! If yous are a theatre inwards a declining concern where novel investments consistently generate less than the terms of capital, your attempts to sustain in addition to grow yourself tin only destroy value rather than increase it. It is amongst this, inwards mind, that I argued inwards an before post that the qualities that nosotros facial expression for inwards a CEO or top managing director volition last dissimilar for companies at dissimilar stages of the life cycle:
Influenza A virus subtype H5N1 visionary at the helm is a huge addition early on inwards corporate life, but it is science equally a concern builder that allows immature companies to scale upwards in addition to larn successful growth companies. As growth companies larn larger, the science laid shifts i time to a greater extent than towards opportunism, the capacity to honor growth inwards novel places, in addition to and so i time to a greater extent than at mature companies, where it management’s mightiness to defend moats in addition to competitive advantages that allow companies to harvest cash flows for longer periods. In decline, it is non vision that yous value but pragmatism in addition to mercantilism, i ground that I chose Larry the Liquidator equally the utilization model. It is worth noting, though, that the means nosotros accolade in addition to wages managers follows the growth advocate dominion book, amongst those CEOs who grow their companies beingness seat on a much higher pedestal (with books written yesteryear in addition to close them in addition to movies on their lives) than those less ambitious souls who presided over the gradual liquidation of the companies nether their command.
Conclusion
I believe that the main ground that nosotros proceed to remain amongst positive growth rates inwards valuation is behavioral. It seems unnatural in addition to fifty-fifty unfair to assume that the theatre that yous are valuing volition run across shrinking revenues in addition to declining margins, fifty-fifty if that is the truth. There are 2 things worth remembering here. The outset is that your valuation should last your endeavor to bear witness to reverberate reality in addition to refusing to bargain amongst that reality (if it is pessimistic) volition bias your valuation. The instant is that assuming a companionship volition shrink may last practiced for that company's value, if the concern it is inwards has deteriorated. I must confess that I don't utilization negative growth rates often plenty inwards my ain valuations in addition to I should describe on them to a greater extent than often non only when I value companies similar brick in addition to mortar retail companies, facing daunting competition, but also when I value technology companies similar GoPro, where the production life wheel is curt in addition to it is hard to maintain revitalizing your concern model.
YouTube Video
Attachments
I believe that the main ground that nosotros proceed to remain amongst positive growth rates inwards valuation is behavioral. It seems unnatural in addition to fifty-fifty unfair to assume that the theatre that yous are valuing volition run across shrinking revenues in addition to declining margins, fifty-fifty if that is the truth. There are 2 things worth remembering here. The outset is that your valuation should last your endeavor to bear witness to reverberate reality in addition to refusing to bargain amongst that reality (if it is pessimistic) volition bias your valuation. The instant is that assuming a companionship volition shrink may last practiced for that company's value, if the concern it is inwards has deteriorated. I must confess that I don't utilization negative growth rates often plenty inwards my ain valuations in addition to I should describe on them to a greater extent than often non only when I value companies similar brick in addition to mortar retail companies, facing daunting competition, but also when I value technology companies similar GoPro, where the production life wheel is curt in addition to it is hard to maintain revitalizing your concern model.
YouTube Video
Attachments
- Percent of negative revenue growth companies, yesteryear sector
- Percent of negative revenue growth companies, yesteryear solid soil in addition to region
DCF Myth Posts
Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool
- If yous accept a D(discount rate) in addition to a CF (cash flow), yous accept a DCF.
- A DCF is an exercise inwards modeling & number crunching.
- You cannot produce a DCF when in that location is equally good much uncertainty.
- It's all close D inwards the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
- The Terminal Value: Elephant inwards the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
- A DCF requires equally good many assumptions in addition to tin last manipulated to yield whatever value yous want.
- A DCF cannot value create elevate or other intangibles.
- A DCF yields a conservative gauge of value.
- If your DCF value changes significantly over time, in that location is something incorrect amongst your valuation.
- A DCF is an academic exercise.
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