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Growth rates the market expects from these expensive stocks

Calculating how much the market expects a richly valued stock to grow can be tricky. The reverse DCF method can help

Growth rates the market expects from these expensive stocks

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When you invest in a company, the underlying assumption is that it will continue to grow in the future. Hence, investing in a company is similar to investing in a perpetual bond with a growing coupon. On buying a perpetual bond, the investor is guaranteed a certain coupon (interest) payment for its entire lifetime. As analysts, our task is to forecast the 'coupons' that equity holders are entitled to from the company.

Forecasting these coupons and then discounting them at an appropriate rate gives us the intrinsic value of the company. In his 1992 shareholders' letter, Warren Buffett wrote, "The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset." This valuation method is known as a discounted-cash-flow (DCF) method.

There are two things of critical importance while applying the DCF method of valuation: growth of cash available to shareholders (free cash flow to equity or FCFE) and the discount rate for these future cash flows. This discount rate is the return that investors expect to receive on investing in equities. In India, this rate is around 15 per cent, assuming a 5-6 per cent risk premium above a sovereign bond yielding 8-9 per cent.

To forecast growth can be a difficult task. That's why, instead of determining growth rate, we can back-calculate and find the implied growth that the market as a whole expects the company to grow at till perpetuity. Finding it helps us to determine if it's even possible for the company to grow at such a rate. This method of finding the implied growth, given today's market capitalisation and a return expectation (discount rate) is known as the reverse DCF method.

We applied the reverse DCF to BSE 500 companies to find out at what rate the market expects them to grow at for the rest of their business lives. Below is a list of a few expensive (P/E > 50) stocks and the implied growth that the market expects from them. To ensure quality, we have considered only those companies that have a five-year median return on equity of over 20.

For a few of them, such as Dr Lal PathLabs, the FCFE over the last 10 years has been really high owing to a small base. It is yet to be seen if these companies can register such high growth in the future as well.

Growth rates the market expects from these expensive stocks