The belief that most firms have positive growth over time is perhaps nurtured by the belief that it is unnatural for firms to have negative growth and that while companies may have a year or two of negative growth, they bounce back to positive growth sooner rather than later. To evaluate whether this belief has a basis in fact, I looked at compounded annual growth rate (CAGR) in revenues in the most recent calendar year (2015), the last five calendar years (2011-2015)and the last ten calendar years (2006-2015) for both US and global companies and computed the percent of all companies (my sample size is 46,814 companies) that have had negative growth over each of those time periods:
Region | Number of firms | % with negative revenue growth in 2015 | % with negative CAGR in revenues: 2011-2015 | % with negative CAGR in revenues: 2006-2015 |
---|---|---|---|---|
Australia, NZ and Canada | 5014 | 41.44% | 36.73% | 28.20% |
Developed Europe | 7082 | 33.42% | 30.03% | 24.25% |
Emerging Markets | 21196 | 43.06% | 29.35% | 21.50% |
Japan | 3698 | 33.41% | 20.76% | 31.80% |
United States | 9823 | 39.69% | 26.76% | 28.10% |
Grand Total | 46814 | 39.86% | 28.64% | 24.69% |
Industry Grouping | Number of firms | % Negative in 2015 | % with Negative CAGR from 2011-2015 | % with Negative CAGR from 20106-2015 |
---|---|---|---|---|
Publshing & Newspapers | 346 | 53.77% | 48.44% | 45.69% |
Computers/Peripherals | 327 | 43.30% | 42.12% | 45.65% |
Electronics (Consumer & Office) | 152 | 43.70% | 47.11% | 44.44% |
Homebuilding | 164 | 31.51% | 22.69% | 35.87% |
Oil/Gas (Production and Exploration) | 959 | 79.22% | 43.75% | 35.40% |
Food Wholesalers | 126 | 37.00% | 30.59% | 33.33% |
Office Equipment & Services | 160 | 40.58% | 32.54% | 33.33% |
Real Estate (General/Diversified) | 418 | 41.33% | 32.72% | 32.52% |
Telecom. Equipment | 473 | 43.00% | 37.36% | 32.43% |
Steel | 757 | 73.23% | 50.65% | 32.08% |
Negative Growth Rates: A Corporate Life Cycle Perspective
If you buy into this notion of a life cycle, you can already see that valuation, at least as taught in classes/books and practiced, is not in keeping with the concept. After all, if you apply a positive growth rate in perpetuity to every firm that you value, the life cycle that is more in keeping with this view of the world is the following:
There is an extension of the corporate life cycle that may also have implications for valuation. In an earlier post, I noted that tech companies age in dog years and often have compressed life cycles, growing faster, reaping benefits for shorter time periods and declining more precipitously than non-tech companies. When valuing tech companies, it may behoove us to reflect these characteristics in shorter (and more exuberant) growth periods, fewer years of stable growth and terminal growth periods with negative growth rates.
Negative Growth Rates: The Mechanics
To illustrate, consider the example of the firm with $100 million in expected after-tax operating income next year, that is in perpetual growth and let’s assume a perpetual growth rate of -5% a year forever. If you assume that as the firm shrinks, there will be no cash flows from selling or liquidating assets, the terminal value with a 10% cost of capital is:
I believe that the primary reason that we continue to stay with positive growth rates in valuation is behavioral. It seems unnatural and even unfair to assume that the firm that you are valuing will see shrinking revenues and declining margins, even if that is the truth. There are two things worth remembering here. The first is that your valuation should be your attempt to try to reflect reality and refusing to deal with that reality (if it is pessimistic) will bias your valuation. The second is that assuming a company will shrink may be good for that company's value, if the business it is in has deteriorated. I must confess that I don't use negative growth rates often enough in my own valuations and I should draw on them more often not only when I value companies like brick and mortar retail companies, facing daunting competition, but also when I value technology companies like GoPro, where the product life cycle is short and it is difficult to keep revitalizing your business model.
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- Percent of negative revenue growth companies, by sector
- Percent of negative revenue growth companies, by country and region
- If you have a D(discount rate) and a CF (cash flow), you have a DCF.
- A DCF is an exercise in modeling & number crunching.
- You cannot do a DCF when there is too much uncertainty.
- It's all about D in the DCF (Myths 4.1, 4.2, 4.3, 4.4 & 4.5)
- The Terminal Value: Elephant in the Room! (Myths 5.1, 5.2, 5.3, 5.4 & 5.5)
- A DCF requires too many assumptions and can be manipulated to yield any value you want.
- A DCF cannot value brand name or other intangibles.
- A DCF yields a conservative estimate of value.
- If your DCF value changes significantly over time, there is something wrong with your valuation.
- A DCF is an academic exercise.