The value of a company or business can be determined based on the future free cash flows that it can generate.
The future free cash flows that the company generate are then discounted to the present based on a discount rate such as Weighted Average Cost of Capital (“WACC”).
This method is referred to as the Discounted Cash Flow (“DCF”) method.
A special scenario of the DCF method happens when one assumes that the company will continue its business in perpetuity and its future free cash flows will continue to grow or decline at a constant rate in perpetuity. We termed this long term stable annual growth rate the Perpetual Growth Rate (“PGR”).
The present value dervied from discounting future cash flows that change at PGR is often referred to as Terminal Value (“TV”).
PGR is typically below the historical GDP growth rate of the major markets that the company operates in which is typically between 2 to 3% for developed economies. According to TradingEconomics.com, GDP growth rate of the United States averaged 2.97% from 1961 to 2021. Although average GDP growth over the past 10 years for the United States is only 2.05%.
For example, if you assume PGR is 5%, you expect the company’s growth to outpace the economy’s growth forever. The estimated PGR of high growth companies may be higher than more matured companies because the higher growth rate during the fast growth periods would bring the average PGR higher than matured companies.
For public listed companies, we know its market capitalisation.
Given the market capitalisation of the public listed company is known and the trailing twelve month’s free cash flow can be calculated from its financial statements, we can work out the PGR of the free cash flow that will support its market value.
In the long term, the real riskless rate converges on the economy’s real-growth rate and the nominal risk free rate converges on the economy’s nominal growth rate. As a rule of thumb, the PGR assumed in DCF method should not be higher than the risk free rate used. This will ensure that PGR is always lower than the discount rate used in the DCF method.
As such if the estimated PGR is much higher than the economy’s long term growth rate or risk free rate, then it is likely that the current share price of the company is richly valued based on high expectations on future growth rate. You will have to form an opinion whether the PGR is reasonable for the company being valued.