Damodaran on Valuation

4.6. CONCLUSION

Forecasting future cash flows is key to valuing businesses. In making these estimates, we can rely on the past history of the firm or on estimates supplied to us by analysts or managers, but we do so at our own risk. Past growth rates are not reliable forecasters of future growth, and management/analyst estimates of growth are often biased. Tying expected growth to the investment policy of the firm—how much it reinvests and how well it chooses its investments—not only is prudent but also preserves internal consistency in valuations.

When valuing equity, especially in high-growth businesses, the bulk of the value will come from the terminal value. To keep terminal values bounded and reasonable, the growth rate used in perpetuity should be less than or equal to the growth rate of the economy, and the reinvestment rate assumed has to be consistent with the growth rate.