Overvalued or on fire? Decoding Terminal Growth Rate for startup valuation

Having been in the entrepreneurial trenches surviving through the excitement and hurdles of the startup world, I have tasted both successes and failures.

One concept that constantly throws a curveball is the Terminal Growth Rate (TGR), which appears to be an insignificant figure but has a huge impact on the value of a startup.

Imagine setting up a startup and devoting your time, energy, and love. The traction is amazing; investors are rushing in while anticipation is at its peak. But then comes the valuation dance! Numbers are thrown around and TGR becomes an invisible controller for a company’s worth.

To put it simply, financial experts forecast a company's cash flows for 5-10 years. However, they also need to predict how much these cash flows will continue to grow beyond that timeframe. This future growth rate is what we call the Terminal Growth Rate.

So, what does it mean to a startup? It is a crucial indicator of the total value of the company. Is it going to be something big and significant, or will it go downhill? The answer lies in striking that subtle balance between ambition and reality within TGR.

Decoding the magic number

The TGR can help a startup estimate how much value the company can grow indefinitely into the future post the initial high growth. It acts like a signpost, directing investment firms toward its possibilities and understanding a company’s valuation.

An increased TGR may lead to a greater valuation. However, one has to be cautious. A goal-oriented TGR can overestimate profits and give an inflated value, which is not sustainable. This is a recipe for an explosive fall making it all the more essential for a company to find the TGR sweet spot.

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Finding the TGR Goldilocks zone

Estimating the TGR involves several methods.

One approach is to use either the industry average growth rate or the country’s economic growth rate, depending on the company’s market and location. The other is historical growth rate analysis, where a company’s growth rate over the past 5-10 years is studied to estimate its Terminal Growth Rate. Industry trends, macroeconomic factors, and management forecasts are also key indicators of a company’s TGR. A TGR that is insightful and strategically sound is obtainable by considering these mixtures of internal and external issues.

According to an Alpha Spread report regarding the HDFC Bank DCF (Discounted Cash Flow) valuation model, the intrinsic value of a single HDFC Bank stock according to the DCF model is estimated at Rs 1,330.92 per share dated April 26, 2024. Based on this assessment, it can be said that the current overvaluation rate of HDFC Bank shares is around 12% given the recent market price equaling Rs 1,513.15 per share.

The discounting cash flows employed are generated by future cash flows from HDFC Bank, which are discounted using an appropriate discount rate back to present value. In other words, this methodology provides an approximation of the true worth of HDFC Bank's stock in light of expectations for its future performance.

The TGR serves as the north star in navigating the complexities of finance and business by helping determine factors like credit risk assessments and scenario analysis.

Allure of high TGR: Silicon Valley mirage?

Silicon Valley survives on game-changing ideas that grow exponentially. Such stories drive young entrepreneurs into the market every day, planning to build the next great unicorn startup. Inevitably, this tempts founders to inflate their TGRs, showing perpetual hyper-growth.

But investors are no fools. They have witnessed enough flash in the pan that startups come and go throughout their careers. When a company has a high TGR but lacks a realistic business model or path to profitability, it raises alarm bells. For them, this means that the company wants out as soon as possible rather than building something sustainable.

The TGR is a useful device, but not the holy grail. While it can bolster a strong valuation argument, it shouldn't overshadow a company's realistic prospects. The primary focus should be on constructing a sustainable business equipped with a capable team, innovative products, and a clear path to profitability, irrespective of TGR fluctuations.

That said, the strategic management of the TGR can prove advantageous or detrimental for both investors and founders alike. Founders must maintain transparency regarding their company's true position, avoiding the temptation to pursue unrealistic TGRs in pursuit of inflated valuations. Rather, the priority should be placed on cultivating businesses rooted in sustainable long-term growth and resilience.

(Eklavya Gupta is Co-founder and Co-CEO of Recur Club)