The Implied Growth Rate in the Valuation of JSE Listed Companies

Abstract

Valuation is the heart of finance and investment decision making. Shareholders, analysts and company officers all need to be able to measure the worth of a company if they are to make investment decisions or alternatively create value within the company. Although several methods exist to value companies, the discounted cash flow (DCF) model is (arguably) both the most theoretically sophisticated as well as the most widely used approach. Its theoretical elegance lies in the fact that it looks to future cash flows which are anticipated from the assets, and discounts these, using simple time value of money principles, to produce a net present value of the business enterprise. Its accuracy depends on the ability of analysts to correctly forecast future cash flows, and in particular, to estimate the growth rate of these in perpetuity. We reverse-engineer the DCF valuation equation to calculate the market’s implied terminal growth rate (ITGR). To do so, we use historical financial statements and market capitalisations of the top 160 Johannesburg Stock Exchange (JSE) listed companies between 1980 and 2015. By constructing four non-overlapping five year periods, we are able to calculate the ITGR by equating free cash flows to the market value of equity for each company. Because the results vary widely, we use medians to estimate an ITGR of between 10% pa and 16% pa. We triangulate our results using other approaches to the problem, and conclude that the values typically shown in textbooks and used by practitioners are too low. We also report that higher values of the ITGR should be employed for more established companies.