I fully understand the sustainable growth rate = ROE*Retention ratio, BUT… I am not fully understanding what g represents. For example, there may be a mature company with an ROE at 7%(and they plow back all of their earnings), but NI, OCF, FCF, FCFF, FCFE, etc. have only been growing at 3%. Why would you use the 7% as your estimate for what your CF’s will grow at (in your DCF), when they are literally growing a at a much slower pace? What is the theoretical backing for this madness? I thought I totally understood this stuff, but sometimes I lose my head! Help!
Shareholders enjoy two sources of return from holding a stock: dividends, and price appreciation. If retention ratio is 100%, there are no dividends, but the price appreciates greatly. If retention ratio is 0%, there are huge dividends and the price doesn’t change. So given the same ROE you can see the firm grow between 0% (or even less I suppose) and that ROE.
let me see if I can get this straight. I can possibly understand this when using g in the gordon growth model equation (with growth at a constant rate). But I don’t see why I would use this for the growth in cash flows for a multi stage DCF, because the CF’s may not actually be growing as fast as ROE with full retention. I think this is the source of my confusion: The growth rate is supposed to be the rate that the Cash flows grow, right? Or is it supposed to be the growth rate of equity? OR can you have 2 growth rates (1 for Cash flows and 1 for equity)? Below is an example with my exact dilemma: i.e. My EQUITY will grow by my ROE (assuming full retention), but my NI will grow less than this. Year 1: ROE - 10% Equity - 100 NI = 10 Year 2: Equity = 110 NI = 10.5 ROE = 9.5% growth in NI: 5% In this method, cash flow growth is not the same as ROE, thus ROE would be an innapropriate g for future cash flow growth, right? Should you use a lower growth rate for your cash flows until reaching and end g? my growth in NI was only 5%, while my ROE was 9.5%. Which g should I use for my cash flows?
can someone please explain this to me, because I cannot find the answer in the curriculum.
The growth rate you use in a DCF model is completely independent of the growth of equity you use in the Gordon growth model. When building out your DCF model, you would never start with the growth of cash flows. This is tantamount to building a car starting with the tailpipe. In the simplest case, you start off with identifying the revenue and expense drivers of the business based on your understanding of the business and the cash flows are the end result of your analysis of future potential revenue growth, margin expansion/contraction, capital investments, etc etc. But like Darien mentioned, as an equity investor, however, you are really only concerned about the capital appreciation and dividends you receive. In the case of a mature (and stable) business, your dividend increases yearly by a constant growth rate i.e. RR*ROE. In the case that you’re not an equity investor (for instance, you may be a debt investor), you may in fact choose to use any one of the other measures you mentioned (e.g. FCFF, FCF, NI, etc.) in order to properly value the business for your needs. Hope this helps.
after 5-10 years, you would want to simply use a growth rate for your cashflows in a DCF (due to the difficulty of forecasting revenues, expenses that far out). The theory behind it is the same(the growth rate in Cash Flows). Your mention of g being independent in a DCF compared to Gordon may be getting closer to my question. Is the g used in your terminal value (CFn/r-g), the same as the growth rate used in your cash flow for the first n periods? Not the same value, but representing the same principle? For the first n periods (or 5-10 periods), is g representing growth in cash flows, whereas in the terminal value g is representing growth in equity?
On the long end of your DCF model you would normally assume a long-run growth rate roughly equal to the long-run growth rate of the economy (otherwise your company may become larger than the entire economy), which you would apply to your last projected year’s revenues. Similarly, you would apply long-run growth/shrinkage rates for other aspects of the business model (e.g. COGS, O/H, etc.). Again, I think you’ve got these concepts confused… the g in a DCF model is completely subjective and represents your best effort at projecting forward cash flows of the business. Also, in a DCF model, you wouldn’t discount the cash flow by r-g… just r, which is a representation of what you think is the appropriate risk figure for the business.
I am talking about your terminal value. For example, your terminal value could be based on a P/E, or it could be based on CFn/r-g. Is the g in the terminal value calculation based on a different theory than the g in cash flows?