Financial trends and growth assumptions.
Financial analysts look to make sense of historic information by recognizing and quantifying trends. Trends are convenient because they appear to follow recognizable and potentially predictable patterns. Such patterns may be used to forecast future operations.
In the development of assumptions in a forecast model, long-term sustainable growth rates are commonly used. The development of these rates can be controversial though, especially in perpetuity based models such as business equity valuations. A discounted cashflow analysis with a terminal period is such an example, as well a single period capitalization method under an income approach.
Earnings Growth vs. Revenue Growth in Valuation
In valuation, long term sustainable growth rates are relevant when using an income approach which assumes a perpetuity or a long-lived model, with an anticipated period of level earnings growth. The difficulty in determining a long term rate is whether the rate is actually sustainable.
Long term growth in an income approach to valuation implies earnings growth, which is distinct from revenue growth. Earnings may or may not grow proportionately to revenue and it can be more difficult to predict an earnings growth rate in light of massive reimbursement changes and the inability to forecast changes in discrete expenses. When selecting the appropriate earnings growth rate it is important to build up a nominal rate which reflects growth from all sources. A nominal rate includes a measure of inflation plus real earnings growth.
Discounted Cashflow and Single Period Capitalization Models
In a single period capitalization method, also known as the Gordon growth model, a discount rate is reduced by the long term growth rate in order to complete the valuation calculation. In a discounted cashflow analysis or multi-period growth analysis, discrete periods in the forecast are discounted to present value. An analyst must forecast sufficient discrete periods in the forecast until a period of level growth is assumed; in valuation this is the terminal period to which a long term sustainable growth rate is applied.
What is a sustainable rate?
A problem arises when the overall rate is unsustainable, or cannot be possible given the context in which the growth occurs. The context in which the earnings growth occurs is the general economy, measured by gross domestic product. The argument is that earnings growth in the long term cannot exceed a nominal rate which includes real GDP, as this is the maximum level of growth experienced by any entity with the greater market. Various sources recommend the use of rates which are based on the producer price index (PPI) or some other measure of inflation added to a modest sustainable earnings growth rate.
One source of data commonly used in valuation is the Livingston Survey. This is a forecast of nominal growth rates consisting of a) CPI economic forecast and b) estimate of real GDP growth. When assessing the rate for use in the terminal period of a discounted cashflow analysis, the growth rate in theory cannot exceed the overall nominal rate. This assumption would cause the model to outpace total economic capacity. This forms a theoretical ceiling.
The use of a single rate in any model can be a blunt instrument. Thus is it is important to calibrate the rate in smaller intervals, use multiple sources of relevant data, and select a rate that does not outstrip the overall economic chassis on which the perpetuity rides. This is especially relevant in startup valuations, bio technology company valuations, and high growth or multi-growth models that encounter periods of volatility. Selecting a rate which are too high or low can have a significant effect on the final result or yield a model which is not logical. This also begs the question of whether a fair market value or commercial reasonableness standard has been violated under healthcare regulatory statutes. A speculative model or high growth model may be possible but unrealistic in some sense. This may lead regulators to perceive the inclusion of strategic considerations, implied referrals or inpatient downstream revenues in the model if it is not sufficiently justified to reflect the growth of the subject entity on its own accord.0