Estimating Exp g
When using DCF models, estimating g (growth rate) is perhaps the most important input we must determine. We have already looked at two other methods of estimating earnings growth, historical trends and the current implied growth rate. The third most common method of estimating the growth rate of cash flows from earnings (g) is by estimating Exp g. This methodology takes into account the two principal determinants of growth, namely quality of investments (Return on Capital ---- ROC) and reinvestment policy (Reinvestment Rate –-- RIR) and is expressed as:
Exp g = (ROC)(RIR)
Where:
ROC = EBIT(1-t) / CapInvest
RIR = Capex – Depr + ? non-cash W/C / EBIT(1-t)
and Non-cash Working Capital is defined as:
Non-cash W/C = Non-cash current assets - non-interest-bearing current liabilities
Non-interest bearing debt generally excludes short term debt and the short term portion of long term debt.
Accounts receivables and inventories are the most important non-cash current assets. For current non-cash liabilities the principle items are accounts payable, taxes payable, and salaries payable. For purposes of analysis, we often treat changes in non-cash working capital as we would “investments” because they affect the analysis of projects as well as aid in the determination of firm value. “Working capital investments” ...