Damodaran on Valuation

4.2. LENGTH OF EXTRAORDINARY GROWTH PERIOD

The question of how long a firm will be able to sustain high growth is perhaps one of the more difficult questions to answer in a valuation, but two points are worth making. One is that it is not a question of whether but when firms hit the stable growth wall. All firms ultimately become stable growth firms, in the best case, because high growth makes a firm larger and the firm's size will eventually become a barrier to further high growth. In the worst-case scenario, firms may not survive and will be liquidated. The second point is that high growth in valuation, or at least high growth that creates value,^[] comes from firms earning excess returns on their marginal investments. In other words, increased value comes from firms having a return on capital that is in excess of the cost of capital (or a return on equity that exceeds the cost of equity). Thus, when you assume that a firm will experience high growth for the next 5 or 10 years, you are also implicitly assuming that it will earn excess returns (over and above the required return) during that period. In a competitive market, these excess returns will eventually draw in new competitors and the excess returns will disappear.

^[] Growth without excess returns will make a firm larger but not more valuable.

We should look at three factors when considering how long a firm will be able to maintain high growth.

1. Size of the firm. Smaller firms are much more likely to earn excess returns and ...