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Adjusted free growth rate

What Is Adjusted Free Growth Rate?

The Adjusted Free Growth Rate is a critical component in financial valuation, particularly within the realm of discounted cash flow (DCF) models. It represents the sustainable, long-term rate at which a company's free cash flow (FCF) is expected to grow beyond a discrete forecast period, often used in calculating the terminal value of a business. This rate is "adjusted" to reflect realistic assumptions about a company's ability to generate cash flow growth in perpetuity, considering factors such as reinvestment needs, industry maturity, and broader economic growth. It belongs to the broader category of Financial Valuation. Unlike a simple historical growth rate, the Adjusted Free Growth Rate incorporates a more nuanced view of a company's long-term potential, aiming for a rate that is both achievable and theoretically sound. Analysts use the Adjusted Free Growth Rate to project future cash flows accurately, which is fundamental for determining a company's intrinsic value.

History and Origin

The concept of projecting future cash flows and discounting them to a present value has roots dating back to ancient times with the practice of compound interest. Discounted cash flow analysis, as a formal method, has been employed in industries since at least the 1800s, with its adoption in the UK coal industry around 18019. The theoretical underpinnings were further developed and formally expressed in modern economic terms by figures like Irving Fisher in his 1930 work, The Theory of Interest, and John Burr Williams in his 1938 text, The Theory of Investment Value8.

The evolution of DCF models led to the necessity of estimating cash flows into perpetuity, giving rise to the concept of Terminal Value. Initially, simple perpetual growth rates were applied. However, as financial modeling matured, the understanding emerged that such growth rates needed "adjustments" to be sustainable and realistic. The development of more sophisticated valuation techniques, including multi-stage DCF models, underscored the importance of a carefully considered Adjusted Free Growth Rate that accounts for a company's transition from high growth to a mature, stable state.

Key Takeaways

  • The Adjusted Free Growth Rate is used in Discounted Cash Flow models to project a company's long-term sustainable growth of free cash flow.
  • It is particularly crucial for calculating the terminal value, which often constitutes a significant portion of a company's total estimated value.
  • Unlike simple historical growth, this adjusted rate considers a company's industry life cycle, reinvestment requirements, and overall economic growth.
  • Setting an appropriate Adjusted Free Growth Rate requires careful judgment and can significantly impact the final Valuation of an asset or company.

Formula and Calculation

The Adjusted Free Growth Rate (g) is typically incorporated into the terminal value calculation of a DCF model, assuming free cash flow will grow at a constant rate indefinitely after the explicit forecast period. The most common formula for terminal value using a perpetual growth model is:

TVN=FCFFN+1WACCgTV_N = \frac{FCFF_{N+1}}{WACC - g}

Where:

  • (TV_N) = Terminal Value at the end of the explicit forecast period (Year N)
  • (FCFF_{N+1}) = Free Cash Flow to the Firm in the first year beyond the explicit forecast period (Year N+1)
  • (WACC) = Weighted Average Cost of Capital, representing the discount rate for future cash flows
  • (g) = Adjusted Free Growth Rate (the perpetual growth rate of free cash flow)

The challenge lies in determining an appropriate (g). It should generally not exceed the long-term nominal growth rate of the economy in which the company operates. This rate implicitly accounts for future Capital Expenditures and working capital needs to sustain that growth. Some approaches estimate this growth rate by considering the company's Return on Invested Capital (ROIC) and its reinvestment rate, suggesting a sustainable growth rate derived from internal efficiency and investment.

Interpreting the Adjusted Free Growth Rate

Interpreting the Adjusted Free Growth Rate involves understanding its implications for a company's long-term sustainability and value creation. A higher Adjusted Free Growth Rate implies greater future cash flows and, consequently, a higher terminal value and overall company valuation. However, this rate must be realistic. A growth rate that is too high, especially one exceeding the long-term economic growth rate, can lead to an inflated and unsustainable valuation.

Analysts often assess the reasonableness of the Adjusted Free Growth Rate by considering the maturity of the company and its industry. A mature company in a saturated market would typically have a lower Adjusted Free Growth Rate compared to a growing company in an emerging sector. Furthermore, the rate should reflect the company's ability to reinvest its Free Cash Flow efficiently to generate that growth. For instance, if a company consistently reinvests capital without generating sufficient returns, a high Adjusted Free Growth Rate would be questionable. The rate also impacts the sensitivity of the overall Valuation to minor changes in assumptions.

Hypothetical Example

Consider a hypothetical company, "GreenTech Solutions Inc.," that has just completed its five-year explicit forecast period for a Financial Modeling exercise. Its projected Free Cash Flow to the Firm (FCFF) for Year 5 is $100 million. For the terminal value calculation, an analyst needs to determine the Adjusted Free Growth Rate.

The analyst observes that GreenTech operates in a mature but stable segment of the renewable energy industry. The national long-term economic growth rate, including inflation, is estimated at 2.5%. The company's historical reinvestment efficiency suggests it can sustain modest growth.

Instead of assuming a high growth rate from its earlier, rapid-expansion phase, the analyst opts for an Adjusted Free Growth Rate of 2.0%, which is slightly below the long-term nominal economic growth rate. This conservative approach accounts for increased competition and limited future expansion opportunities.

If GreenTech's Weighted Average Cost of Capital (WACC) is 8%, the estimated FCFF for Year 6 (FCFF$_{N+1}$) would be $100 million * (1 + 0.02) = $102 million.

Using the terminal value formula:

TV5=$102 million0.080.02=$102 million0.06=$1,700 millionTV_5 = \frac{\$102 \text{ million}}{0.08 - 0.02} = \frac{\$102 \text{ million}}{0.06} = \$1,700 \text{ million}

This $1,700 million Terminal Value would then be discounted back to the present day along with the explicitly forecasted cash flows to arrive at GreenTech's total enterprise value.

Practical Applications

The Adjusted Free Growth Rate is primarily applied in Discounted Cash Flow (DCF) models, which are widely used for various purposes in corporate finance and investment analysis.

  • Corporate Valuation: It is a core input when valuing private companies, public companies for mergers and acquisitions, or specific projects. The CFA Institute highlights that free cash flow models are frequently used by analysts for company and equity valuation, providing an economically sound basis for determining intrinsic value7.
  • Investment Decisions: Investors use the Adjusted Free Growth Rate to assess the long-term prospects and intrinsic value of potential investments. A well-justified Adjusted Free Growth Rate helps in determining whether a stock is undervalued or overvalued, guiding investment decisions to maximize Shareholder Value.
  • Strategic Planning: Companies utilize this metric internally for strategic capital allocation decisions. By forecasting future free cash flows with an Adjusted Free Growth Rate, management can make informed choices about reinvestment in the business, debt reduction, or returning cash to shareholders through dividends or share buybacks.
  • Credit Analysis: Creditors may consider a company's projected free cash flow, influenced by the Adjusted Free Growth Rate, to gauge its ability to meet future debt obligations and assess its creditworthiness. The ability to generate consistent Operating Cash Flow is a key indicator of financial health.

Limitations and Criticisms

While the Adjusted Free Growth Rate is essential for Valuation models, it is subject to several limitations and criticisms:

  • Subjectivity and Assumptions: Determining an appropriate Adjusted Free Growth Rate is highly subjective. It relies heavily on analysts' assumptions about future economic conditions, industry dynamics, and a company's competitive landscape. Small changes in this rate can lead to significant variations in the calculated Terminal Value and overall valuation6. Valuations can become overly sensitive to this assumption, especially when the terminal value constitutes a large portion of the total value5.
  • Unrealistic Perpetuity Assumption: The concept of perpetual growth itself can be criticized as unrealistic. No company can grow indefinitely at a consistent rate, especially one exceeding the broader economic growth rate4. Markets are competitive, and excess returns are expected to diminish in the long run3.
  • Impact of Earnings Management: While based on cash flows, underlying accounting practices and management decisions can still influence the inputs used to derive future free cash flows. Variations in Accounting Practices and the impact of non-recurring items can complicate the calculation of Free Cash Flow, making comparisons challenging2.
  • Forecasting Challenges: Forecasting free cash flows for a long explicit period, let alone beyond it, is inherently difficult due to market volatility and unforeseen events. A cash flow forecast, by nature, is based on assumptions about future events and conditions, such as sales, costs, and interest rates, which may not hold true in reality1. This challenge directly impacts the reliability of the Adjusted Free Growth Rate.

Adjusted Free Growth Rate vs. Terminal Growth Rate

The terms "Adjusted Free Growth Rate" and "Terminal Growth Rate" are often used interchangeably, and in practice, they refer to the same concept: the assumed constant growth rate of free cash flow in the perpetuity period of a DCF model.

However, the "adjusted" in Adjusted Free Growth Rate emphasizes the deliberate process of modifying raw historical growth rates or simple projections to align them with more realistic, sustainable long-term economic and industry conditions. It highlights that the chosen rate is not merely an extrapolation but a carefully considered input that has been "adjusted" for factors that limit indefinite high growth.

For instance, a company might have experienced 20% annual Net Income growth during its rapid expansion phase. However, an analyst would apply a much lower, "adjusted" growth rate (e.g., 2-3%) for the terminal value calculation, reflecting the reality that such high growth is unsustainable in perpetuity. The emphasis is on the qualitative and quantitative adjustments made to arrive at a believable long-term rate, rather than just stating it as a generic "terminal growth rate." Both terms relate to projecting cash flows beyond the discrete forecast period in a Cash Flow Statement-based valuation.

FAQs

What factors influence the Adjusted Free Growth Rate?

The Adjusted Free Growth Rate is influenced by a company's industry maturity, competitive landscape, long-term macroeconomic growth projections (including inflation), and the company's expected ability to reinvest its Free Cash Flow efficiently. It should generally not exceed the nominal long-term growth rate of the economy.

Why is the Adjusted Free Growth Rate typically low (e.g., 2-4%)?

It is kept low because no company can grow at an exceptionally high rate indefinitely. In the long run, competition and market saturation tend to normalize growth rates to be at or below the overall economic growth rate. A higher rate would imply that the company will eventually become larger than the economy itself, which is not feasible. This aligns with the concept of a stable-growth phase in Financial Modeling.

How does the Adjusted Free Growth Rate affect a company's valuation?

The Adjusted Free Growth Rate significantly impacts the Terminal Value component of a DCF valuation, which often accounts for a substantial portion of a company's total estimated value. Even small changes in this rate can lead to large differences in the final valuation, highlighting its sensitivity and the importance of a well-justified assumption.