The value of a firm is the present value of expected future cash flows generated by the firm. The most critical input in valuation, especially for high-growth firms, is the growth rate to use to forecast future revenues and earnings. This chapter considers how best to estimate these growth rates for firms, including those with low revenues and negative earnings.
There are three basic ways of estimating growth for any firm. One is to look at the growth in a firm's past earnings—its historical growth rate. While this can be a useful input when valuing stable firms, there are both dangers and limitations in using this growth rate for high-growth firms. The historical growth rate can often not be estimated, and even if it can, it cannot be relied on as an estimate of expected future growth.
The second is to trust the analysts who follow the firm to come up with the right estimate of growth for the firm, and to use that growth rate in valuation. Although many firms are widely followed by analysts, the quality of growth estimates, especially over longer periods, is poor. Relying on these growth estimates in a valuation can lead to erroneous and inconsistent estimates of value.
The third is to estimate the growth from a firm's fundamentals. A firm's growth ultimately is determined by how much is reinvested into new assets and the quality of these investments, with investments widely defined to include acquisitions, building distribution channels, or even ...