Discounted Cash Flow Model - Are Massive Variations Expected?

Question

After reading "How to Analyse Companies and Value Shares" by the FT, I've made my own Excel DCF model for GlaxoSmithKline. The problem is that it gives huge variations in Enterprise Value if I only slightly adjust the model inputs. For example:

• If I use a modest steady state growth rate, e.g. 5.5% I get a negative Enterprise Value (EV). I don't believe GSK will be worth a minus investment in several years to come.

  • If I use a very low steady state growth rate,say 2% I suddenly get an EV of £240 billion!

In other words, if I use a lower growth rate, I get a higher valuation (as the Weighted Average Cost of Capital is now higher than the growth rate).

I'd be grateful if someone could take a look at the model and provide some guidance on how to DCF properly, because at the moment, given the variations, the valuations just seem wrong. I've double checked the calculation formulas which seem to be correct.

Advice appreciated.

Thanks

Answer 1

Your model is fine, it is your assumptions that are incorrect. The steady state growth rate (i.e. for all eternity) cannot be higher than WACC, both mathematically (as it may give negative EV) but also logically.

If your growth rate is larger than the cost of capital (i.e. WACC) the company would grow into infinity and in the end ending up being the entire economy.

I found this statement by (jhoratio) which summarizes pretty well

Growth rates can exceed the cost of capital for very short periods of time, but we're talking about a growth rate IN PERPETUITY here. Any company whose growth rate exceeds the required rate of return would a) be a riskless arbitrage and b) attract all the money in the world to invest in it. The company would eventually become the entire economy with every human being on earth working for it.