Inflation as Terminal growth rate

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Permalink Reply by Manish Rawat on February 15, 2010 at 5:31am

I agree to what you mentioned Sachcha...I understand that the share price will fall to the level, which makes it attractive to the new investors...

This is the market hypothesis. I, however, am referring to the CAPM model...how do we factor that in our valuation...

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Permalink Reply by Sachidanand (Sacha) Singh on February 15, 2010 at 6:37am

But, my comments were entirely based on CAPM.

One of the most important results of Bill Sharpe’s analysis published as "A Simplified Model of Portfolio Analysis" that eventually became famous as the CAPM, was that only one factor caused correlation, and that, prices would adjust until expected returns were higher for securities that had higher systemic risks.

Any other scenario that does not accept it would be deviating from CAPM.

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Permalink Reply by Manish Rawat on February 15, 2010 at 6:55am

Thanks for your response Sachcha...

Lets take it this way...what should be the terminal period growth rate and what would be the underlying assumption?

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Permalink Reply by Sachidanand (Sacha) Singh on February 15, 2010 at 8:36am

Please allow me a digression from your recent post giving the two scenarios. I am sticking my neck out on what should be the stable growth rate for a target firm, in fuller details.

I had earlier said that this rate cannot be higher than the growth rate of the economy. I still maintain that. (But it does not mean that it cannot be lower than the growth rate of the economy, as I will come to later.)

As it is to help us in valuation, we need to look for sources of value. Value comes from growth if while achieving growth the firm is also earning a return on its capital that is higher than its cost of capital. On the other hand growth cannot come without investment. To be sure, limited period growth can be achieved by improving efficiency but one cannot go on improving efficiency for ever; the permanent growth rate can come only from making continuous reinvestment. Please see Prof. Ignacio Vélez-Pareja’s comments on last page.

But one cannot go on making reinvestment to grow if other firms can also invest in the same line and (by competition) reduce the return on capital. Thus growth becomes a function of competition, rather of how long the target firm can maintain its competitive advantage over others.

It is reasonable to presume that after some time others will join in and the firm will not be able to earn excess return i.e. its return on capital will become equal to its cost of capital. The firm will stop growing in value sense i.e. its growth will stop adding to its value. Please note that it may grow at or higher than or lower than inflation rate but if its return on capital just equals its cost of capital its growth will not add value. Naturally, at this stage the firm would rather distribute the cash flows among capital providers than reinvest.

The growth may continue at say the growth rate of the economy (or of the global economy for a global firm – please see Anshul’s post on the previous page). But it may also be lower. Suppose a new cheaper and cleaner technology sweeps our firm’s area of operation; the new entrants will grow at a much faster rate than the economy and our target will naturally grow at a much slower rate or even negative rate as it will be losing market share.

We had Gestetner in India in cyclostyling. It sold cyclostyling machines and consumables – inks and stencils. It grew at a rapid rate and then had captured the market thoroughly and was merely growing at a rate higher than the Hindu growth rate. Around mid 1970’s photocopiers appeared on scene, offering a new, cleaner (less messy) and faster solution to our duplication needs and cheaper too if we needed say less than 10 copies. Gestetner started faltering and over next 20 years or so just went down the horizon.

The idea behind this longish (and some would say didactic) post is that while valuing let us not get bogged with math and Excel sheet, important though they are, conceptual clarity on what drives value is what is most important.

Equilibrium inflation rate shall always be lower than Rf, which is but (1+Real Rf)*(1+inflation rate). In my opinion it should have no significance so far as stable growth rate is concerned.

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Permalink Reply by Manish Rawat on February 15, 2010 at 8:49am

Dear Sachcha,

Thank you very much for the detailed explanation. I really appreciate your help on the topic.

I understand the basic fundamental of valution and factors that we look at...and agree that we should not limit it to maths or excel. However, the irony is that we need to quantify our assumptions and calculate the valuation...and that is where it is very subjective...

Got my head in something urgent...and will come back on this in sometime

Anyways, thanks a lot for your help and I appreciate your patience!

Manish

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