Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CONCLUSION

The results discussed here raise interesting questions about both the valuation process for high-growth stocks and the subtle implications of standard growth models. As one delves deeply into patterns of company growth, one finds that even simple earnings growth is implicitly associated with considerably more-complex processes than are assumed in standard growth models. At the beginning, the typical high reinvestment rates that fuel earnings growth also add to the company’s capital base and enhance its production and distribution capacity. The increased sales and earnings generated by these capacity enhancements are sources of high margin flows, which is fine because they provide substantial profits.

The problem arises when these high-margin earnings move toward competitive equilibrium. With a Q-type definition of such an equilibrium, the high-margin flows must descend toward margin levels that would just satisfy new competitors. To the extent that an investor would begin to receive a substantial payout only in the postgrowth period, such a margin shift could materially affect the company’s valuation. In essence, reinvestment-driven growth represents a leveraging of competitively vulnerable earnings. It is tantamount to a repeated doubling-up of the stakes in the face of escalating risks. If the franchise ride can be extended, however, with new or existing products, these terminal-phase effects may be muted.11

This chapter focused on the one- and two-phase valuation ...