1. Part I: Checking the Perpetuity Growth Rate
The next element we will test is the Perpetuity Growth Rate.
2. Checking the Perpetuity Growth Rate
The perpetuity growth rate or PGR is one of the most often abused inputs in valuation. The PGR is often a key driver of the terminal value, which in turn usually contributes to a very large portion of the valuation. The reason for this is that many analysts do not link the PGR with reinvestment needs of the firm in the terminal period. This allows the firm to grow without paying for the additional growth, which sometimes leads to very high terminal values.
3. Determinants of the Perpetuity Growth Rate
The PGR is a sustainable growth rate, which means that it is a growth rate that should be supported by the firm's operations. This means that the PGR should be financed by the profits of the firm. Having said that, the PGR is bounded by its relationship with the Reinvestment Rate and Return on Equity.
The Reinvestment Rate is equal to the reinvestment amount, which is the Capital Expenditures plus Increases in Working Capital less depreciation and amortization, divided by the After-Tax Income. In a steady state, the firm must be returning an amount equal to its cost. That is, you reach a point where the firm makes zero economic profit. So in the long-run Return on Equity should equal the cost of equity. For our purposes, we will assume Return on Equity equals the Cost of Equity.
What this formula says is that, all else equal, if we reinvest more of the income into the firm, the PGR will increase and if we are able to generate a higher return on new equity capital, the PGR will also increase.
4. Example
Let's go through some examples to make this more clear. First, let's assume that a firm has a reinvestment rate of 20% and an ROE of 10%. Suppose that you think the firm should have a PGR of 4%. Let's check whether the firm can indeed sustain that rate?
To get to the sustainable growth rate, we multiply the reinvestment rate by the ROE. The output shows that at a 20% reinvestment rate, the firm can only support a 2% PGR and not a 4% PGR.
Now, we could also ask, given the firm's ROE of 10%, how much do they have to reinvest in order to support a PGR of 4%? To do so, we divide the PGR of 4% by the ROE of 10%. The output shows that the firm needs to reinvest 40% of its After-Tax Income or double its current reinvestment rate.
5. Let's practice!
In the following exercise, you will be tested on your understanding of the PGR. You will first be asked to calculate the reinvestment rate and then the expected growth rate. Let's practice.