Note: small growth has not typically traded at the discounts we see today and those implied by small-firm failure rates.
Small value multiple divided by large value multiple, and small growth multiple divided by large growth multiple. Indeed, Fama and French argued that, historically, the percentage of IPOs that survive 10 years is strongly predicted by the percentage of those firms that are “low-profitability, high-growth firms” with the probability of a new list surviving its first 10 years falling from “60.6% for the cohort of 1973 to 46.9% for the 1991 cohort.”īut although the market has generally priced the difference between large and small companies correctly, we’ve noticed that it has often gotten the mortality discount wrong when it comes to small growth stocks.įigure 6: Premium (Discount) for Small vs. According to the study, growth stocks with blazing trailing returns historically outnumbered value stocks with poor trailing returns in mortality rates.
But, in fact, the major study on distress risk predictors among growth and value stocks found that high revenue growth rates and high stock price returns have not historically mitigated that mortality risk. We associate distress with shrinking firms in outdated and struggling industries. Many may think that growth stocks should survive more often given their more exciting futures compared to value stocks. Small Value: Do the Valuations Make Sense? To see where markets perhaps may have gotten things wrong historically under this framework, we need an example of markets paying more to take on more risk…to the world of small growth stocks. The market is, therefore, accurately pricing in the relative risk of small caps relative to large caps: small stocks (in general) have higher termination rates and trade at lower valuations as a result, as we’ve observed. If history is any guide, 10 years from now, among seasoned (i.e., not recently IPO-ed) firms, approximately 1.4% of large firms and 19% of small firms will have died a bad death, according to research from Fama and French that matches other long-term studies.įigure 4: 10-Year De-Listing for Cause Rates for Seasoned Firms Termination Rates Matter as Much as Terminal Values Long-term studies show that a substantial percentage of public companies don’t survive for 10 years. Investors are focusing too much on terminal values and not enough on termination rates. Yet the resulting growth multiples are an extreme bet, and almost 100% predicated on what happens beyond the next 10 years.īut it’s not just that forecasts of r and g beyond the near-term future (when it matters in the formula) are likely completely speculative that makes this logic dangerous. This simple model suggests that basic assumptions about future high growth and future low interest rates can explain today’s high prices. The combination of low discount rates and high projected growth is a particularly dangerous cocktail: as r and g converge, nearly 100% of the company’s value is based on far-off speculation 10+ years in the future. Valuations increase exponentially as r and g converge.įigure 2: Two–Percentage Point Decrease in Discount Rate Triples Price A two–percentage point decrease in the discount rate, however, from 5% to 3%, results in a tripling of the enterprise value to $102. Under these conditions, the present value of the firm is $34.
Trminal growth rate of stock free#
Under the model, valuations are extremely sensitive to small changes in projected discount and growth rates.Ĭonsider, for instance, a company with free cash flow of $1 today, and assume a growth rate of 2% and a discount rate of 5% into perpetuity. The most popular application of this asset pricing model is the discounted cash flow (DCF) method, which hinges on two key factors: r (the discount rate) and g (a company’s long-term growth rate). This simple argument is theoretically very true in terms of the most basic valuation proposition used in asset pricing: the value of an asset is worth the sum of its discounted future cash flows in perpetuity. Source: FRED for interest rates, Ken French Library for price-to-cash-flow multiples on the extreme 95th percentile breakpoint of all stock valuations in the US market each June.