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Creative Destruction and the Perpetual Growth Assumption

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  • Sutter Securities Financial Services, San Francisco

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In determining terminal value in a discounted cash flow (DCF) valuation, it is usually assumed that a mature company will grow at a constant rate in perpetuity. The impact of creative destruction and disruptive innovation interrupts and reverses historical growth patterns. If to the extent that the assumption of constant perpetual growth is invalid, the commonly used growth model in DCF analyses will overstate terminal value and cause overvaluations. The perpetual growth concept needs to be reexamined. Companies, like people, have life spans. Valuators should recognize the risks of corporate decline and corporate mortality and make corresponding appropriate adjustments in their valuations. It is necessary to develop appropriate premiums for mortality risks that can be applied for corporate valuations. Studies of corporate decline and mortality should focus on companies that suffer material declines because of poor performance or whose existence terminates. The studies need to analyze the data by industry and should measure the effect of size on mortality, considering such variables as revenues, gross margin, number of employees, tangible assets, and R&D expenditures.
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Creative Destruction and the Perpetual Growth Assumption
Gilbert E. Matthews
In determining terminal value in a discounted cash flow (DCF) valuation, it is usually
assumed that a mature company will grow at a constant rate in perpetuity. The impact of
creative destruction and disruptive innovation interrupts and reverses historical growth
patterns. If to the extent that the assumption of constant perpetual growth is invalid, the
commonly used growth model in DCF analyses will overstate terminal value and cause
overvaluations.
The perpetual growth concept needs to be reexamined. Companies, like people, have
life spans. Valuators should recognize the risks of corporate decline and corporate
mortality and make corresponding appropriate adjustments in their valuations.
It is necessary to develop appropriate premiums for mortality risks that can be applied
for corporate valuations. Studies of corporate decline and mortality should focus on
companies that suffer material declines because of poor performance or whose
existence terminates. The studies need to analyze the data by industry and should
measure the effect of size on mortality, considering such variables as revenues, gross
margin, number of employees, tangible assets, and R&D expenditures.
The renowned economist Joseph Schumpeter developed
the concept of creative destruction in his classic 1942 book
Capitalism, Socialism and Democracy.
1
Creative destruc-
tion is the process by which new things bring about the
demise of the things that existed before them, i.e., the
continuing product and process innovation mechanism by
which new production units replace outdated ones.
A related concept, disruptive innovation, was introduced
by Clayton Christensen in his 1997 book The Innovator’s
Dilemma.
2
Disruptive innovation is primarily technology-
backed innovation that creates a new market and displaces
older business structures. Prime examples are Amazon’s
impact on brick-and-mortar retailers and digital imaging’s
effect on cameras and film manufacturing and processing.
The most influential business theory of recent years is [the]
theory of disruptive innovation. Think of classified ads
(Craigslist), long-distance calls (Skype), record/media stores
(iTunes), taxis (Uber), and newspapers (Twitter).
3
In determining terminal value in a discounted cash flow
(DCF) valuation, it is usually assumed that a mature
company will grow at a constant rate in perpetuity.
4
The
impact of creative destruction and disruptive innovation
interrupts and reverses historical growth patterns. If the
assumption of constant perpetual growth is invalid, the
commonly used growth model in DCF analyses will
overstate terminal value and cause overvaluations.
James Morris perceptively points out:
[R]elatively little attention is given to expected [corporate]
life in the valuation literature and in the valuation methods
used by practitioners. . . . The constant growth model is as
accurate as the assumptions on which it is based: an infinite
horizon and growth that is expected to be the same rate
every period forever. If the firm’s circumstances do not fit
these assumptions, the model can lead to an inaccurate
valuation. How inaccurate depends on how far the
assumptions depart from reality.
5
The Flawed Perpetual Growth Assumption
The perpetual growth concept needs to be reexamined.
Companies, like people, have life spans. Valuators should
recognize the risks of corporate decline and corporate
Gilbert E. Matthews is Chairman and Senior Managing Director at
Sutter Securities Incorporated, San Francisco, California.
1
Joseph A. Schumpeter, Capitalism, Socialism and Democracy (London:
Routledge, 1942).
2
Clayton M. Christensen, The Innovator’s Dilemma: Why New
Technologies Cause Great Firms to Fail (Boston: Harvard Business
School Press, 1997).
3
‘‘Jeremy Corbin, Entrepreneur,’’ The Economist, June 15, 2017, 53.
4
There are some companies for which perpetual growth is usually not
assumed, e.g., extractive industries with diminishing reserves and
companies dependent on patent protection.
5
James R. Morris, ‘‘Life and Death of Businesses: A Review of Research
on Firm Mortality,’’ Journal of Business Valuation and Economic Loss
Analysis 4 (2009), Art. 3, 1; see also Morris, ‘‘Firm Mortality and
Business Valuation,’’ Valuation Strategies (September/October 2009),
6–13, 46–47.
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Business Valuation Reviewe
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Ó2018, American Society of Appraisers
mortality and make correspondingly appropriate adjust-
ments.
The assumption of perpetual growth ignores the
consequences of creative destruction and disruptive
innovation and the obvious fact that companies decline
and often fail. The reasons for these declines are varied:
they include technological changes, obsolescence, com-
petition, mismanagement, and even fraud. Declines may
be gradual, but we also have seen unexpected sudden
financial disasters (e.g., Lehman Brothers, Bear Stearns,
Enron, WorldCom, and HealthSouth).
In the middle of the last century, analysts assumed the
continuing growth of steel companies, but U.S. steel
production peaked in 1973, and electric-arc furnaces,
excess capacity, and international competition have
eroded the revenues and earnings of the major steel
producers. Department stores were considered to be a
classic example of steady growth, but online distribution
and specialty retailers have devastated them. Eastman
Kodak and Polaroid, once considered prime growth
companies, lost their markets to electronic imaging and
went bankrupt. New energy sources are replacing coal.
More recently, leading high-tech companies such as AOL
and Yahoo have lost out to nimbler competitors, and
Netflix destroyed Blockbuster and disrupted the movie
industry.
The Forbes list of the 100 largest U.S. companies in
1917 included sixty-one that no longer existed in 1987,
and only eighteen of the companies remained in the top
100. Six of these have subsequently been bankrupt, and
three have verged on bankruptcy. Only four remain in the
top 100.
Only 12% of the companies in the Fortune 500 in 1955
were included in 2017.
6
Companies that were included in
the 1958 S&P 500 had been in the index for an average of
sixty-one years (based on seven-year rolling averages).
By 1980, the average tenure had declined to about
twenty-five years. Over the decade to 2012, about half of
the S&P 500 was replaced.
7
Now the average tenure is
about eighteen years. Many companies have necessarily
been dropped from the index due to acquisitions, but a
significant number were dropped because of poor
performance. A 2017 study by Credit Suisse determined
that 55.4% of the removals from 2000 through 2016 were
due to acquisitions, 32.5% due to failure, and 12.1% for
other reasons such as reduced market valuation;
8
however, it should be noted that some of the acquisitions
were of troubled companies, e.g., JPMorgan Chase’s
acquisition of Bear Stearns. Table 1 shows examples of
firms dropped from the S&P 500 because of poor
Table 1
Examples of Companies Dropped from S&P 500 Due
to Poor Performance: 2001–2018
Company Reason for Change
American Airlines Restructured in bankruptcy
Avon Products Low equity value
Bear Stearns Insolvent, taken over by
JPMorgan Chase
Eastman Kodak Restructured in bankruptcy
Enron Bankrupt, ceased operations
Global Crossing Restructured in bankruptcy
Lehman Brothers Bankrupt, ceased operations
Maytag Financially troubled, acquired
by Whirlpool
Merrill Lynch Financially troubled, acquired
by Bank of America
The New York Times Slow growth
Palm Sales decline and financial problems
RadioShack Financial problems
United States Steel Low equity value
Sears Restructured in bankruptcy
Table 2
Examples of Healthy Companies Dropped from S&P
500 Due to Acquisition: 2001–2018
Company Reason for Change
Anheuser-Busch Acquired by InBev
DuPont Acquired by Dow Chemical
Dr Pepper Snapple Acquired by Keurig Green
Mountain
H. J. Heinz Taken private
Monsanto Acquired by Bayer
Reynolds American Acquired by British American
Tobacco
Safeway Taken private in LBO
Staples Taken private in LBO
Starwood Hotels and Resorts Acquired by Marriott
International
Time Warner Acquired by AT&T
Time Warner Cable Acquired by Charter
Communications
Toys ‘‘R’’ Us Taken private in LBO
Wendy’s Merger with TriArc
Wyeth Acquired by Pfizer
6
Mark J. Perry, ‘‘Fortune 500 Firms 1955 v. 2017: Only 60 Remain,
Thanks to the Creative Destruction That Fuels Economic Prosperity,’’ at
http://www.aei.org/publication/fortune-500-firms-1955-v-2017-only-12-
remain-thanks-to-the-creative-destruction-that-fuels-economic-
prosperity/.
7
Richard N. Foster, ‘‘Creative Destruction Whips through Corporate
America,’’ Innosight Executive Briefing, Winter 2012, at www.
innosight.com/insight/creative-destruction-whips-through-corporate-
america_final2015.pdf.
8
Michael J. Mauboussin, Dan Callahan, and Darius Majd, ‘‘Corporate
Longevity,’’ Credit Suisse, February 7, 2017.
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— Winter 2018 Page 151
Creative Destruction and the Perpetual Growth Assumption
performance, and Table 2 shows examples of healthy
firms dropped because they were acquired.
For companies that mature and become listed on an
exchange, a 2011 study by Loderer, Neusser, and
Waelchli concluded that, after listing on an exchange,
the frequency of corporate failure gradually falls ‘‘ from
about 3% [annually] in early years to 0.3% before
companies get to be 75 [years old].’’
9
A working paper
from the Tuck School of Business reviewed all 29,688
U.S. and foreign firms in the Compustat Capital IQ data
base that commenced trading in each year from 1960
through 2009.
10
It studied the five-year survival rates by
decade and demonstrated that the chance of survival
declined from 92% in the 1960s to 63% in the decade to
2009, as shown in Figure 1.
Data based on small companies confirm that they have
a greater risk of decline or death. According to the U.S.
Small Business Administration (SBA), about 68% of all
new businesses are still operating two years later, and
about 50% are in business five years later.
11
Although numerous published studies have also
concluded that corporate mortality risk decreases over
time, some have arrived at a contrary result. For example,
a study published in 2015 used Compustat data to
examine the lifespans of more than 25,000 public
companies and concluded that the mortality rate of public
companies is not a function of time.
12
However, it is undisputed that mortality rate is a
function of the size of a company and that smaller firms
have greater risk. Figure 2, in which the largest firms (by
market value of equity) are in the first decile and the
smallest are in the tenth decile, shows a meaningful
correlation between equity value and corporate mortality.
Historically, there is a similar correlation between number
of employees and corporate mortality.
13
What are the reasons for this attrition? Some companies
disappear because they are absorbed in mergers and
acquisitions. A substantial portion of these acquired
companies are prosperous and growing, but some of those
target companies are declining and/or financially trou-
bled. Some companies are dropped from indices because
Figure 1
Likelihood of Surviving the First Five Years of Listing (Govindarajan and Srivastava, ‘‘ Strategy When Creative
Destruction Accelerates,’’4)
9
Claudio F. Loderer, Klaus Neusser, and Urs Waelchli, ‘‘Firm Age and
Survival,’’ SSRN (2011), at www.ssrn.com/abstract¼1430408.
10
Vijay Govindarajan and Anup Srivastava, ‘‘Strategy When Creative
Destruction Accelerates,’’ Tuck School of Business Working Paper
(2016), at ssrn.com/abstract¼2836135.
11
U.S. Census Bureau, Center for Economic Studies, Business Dynamics
Statistics, at www.census.gov/ces/dataproducts/bds/data_firm.html. The
data cover the years 1980–2014.
12
Madeleine I. G. Daepp, Marcus J. Hamilton, Geoffrey B. West, and
Lu´
ıs M. A. Bettencourt, ‘‘The Mortality of Companies,’’ Journal of the
Royal Society Interface 12 (2015), at rsif.royalsocietypublishing.org/
content/12/106/20150120. However, their definition of lifespan included
mergers and acquisitions, which were the terminal events for about half
of the companies.
13
Timothy Dunne, Mark Roberts, and Larry Samuelson, ‘‘The Growth
and Failure of U.S. Manufacturing Plants,’’ Quarterly Journal of
Economics 104 (1989), 671–698.
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of financial problems that slow or reverse their growth.
Others are restructured in bankruptcy, and some simply
cease operations and die. Troubled companies that are
rescued by acquirors rebut the assumption of perpetual
growth, as do companies that cease growing, suffer from
severe financial problems, or cease operations.
Corporate Mortality Can Be a Material Risk Factor
Morris considers the issue of firm survival and
mortality, studies available data for mortality of small
entities, and addresses the impact of mortality risk on
corporate valuation. In Figure 3, Morris showed the
impact of firm mortality on DCF value, where k ¼
discount rate and g ¼growth rate.
14
The impact of disregarding mortality risk can be
substantial. For illustrative purposes, we show in Table 3
that if the risk of failure in any given year is 0.75% and is
constant year to year, the cumulative risk of failure within
fifteen years is 10.7% and within twenty-five years is
17.2%. Table 4 shows that if we assume that the risk in
years 1–5 is 0.75% and declines 5% per year after year 5,
the cumulative risk of failure within fifteen years is 9.1%
and within twenty-five years is about 12.1%.
Figure 2
Exit Rates for Firms Due to Unfavorable Mortality for Selected Size Categories (Morris, ‘‘Life and Death of Businesses,’’
3, citing Maggie Queen and Richard Roll, ‘‘Firm Mortality: Using Market Indicators to Predict Survival,’’ Financial
Analysts Journal 43 [1987],9)
14
Morris, ‘‘Life and Death of Businesses,’’ 3.
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Creative Destruction and the Perpetual Growth Assumption
This magnitude of the impact of firm mortality on firm
value is a function not only of the mortality risk, but also
of the growth rate and the discount rate. The impact
increases at higher growth rates but decreases at higher
discount rates. The quantified impact of corporate
mortality becomes de minimis at high discount rates.
A 2014 article by Morris Danielson and Jean Heck
points out the potential valuation errors inherent in using
the perpetual growth assumption:
[P]rice estimates from the constant growth model can overstate
a stock’s intrinsic value by a sizeable amount—in some cases
the valuation errors can be two or three times the underlying
intrinsic value! The potential overstatement increases as the
firm’s dividend yield decreases, shifting a greater portion of
the expected cash flow into later years. . . . [T]he constant
growth model is most useful when the firm faces a low default
probability, when only a small portion of the growth will be
the result of positive net present value investments, and when
the firm’s dividend yield is sufficiently large. In all other cases,
value estimates obtained from the constant growth model have
the potential to significantly overstate value. The ironic
implication is that the perpetual growth model is most useful
when it is needed least. That is, when the model is used to
value low-growth, high-payout firms.
15
Table 3
Cumulative Risk of Failure Assuming Constant Annual Rate
Risk per Year (%)
Cumulative Risk 0.25 0.50 0.75 1.00 1.50 2.00
10 years 2.47 4.89 7.25 9.56 14.03 18.29
15 years 3.69 7.24 10.68 13.99 20.28 26.14
20 years 4.88 9.54 13.98 18.21 26.09 33.24
25 years 6.07 11.78 17.16 22.22 31.47 39.65
Table 4
Cumulative Risk of Failure Assuming that Risk Declines 5% per Year after Year 5
Risk per Year, Years 1–5 (%)
Annual and Cumulative Risk 0.25 0.50 0.75 1.00 1.50 2.00
Annual risk in year 10 0.19 0.39 0.58 0.77 1.16 1.55
Annual risk in year 15 0.15 0.30 0.45 0.60 0.90 1.20
Annual risk in year 20 0.12 0.23 0.35 0.46 0.69 0.93
Annual risk in year 25 0.09 0.18 0.27 0.36 0.54 0.72
Cumulative risk: 10 years 2.30 4.55 6.76 8.92 13.10 17.12
Cumulative risk: 15 years 3.11 6.13 9.06 11.91 17.35 22.48
Cumulative risk: 20 years 3.73 7.33 10.80 14.15 20.50 26.39
Cumulative risk: 25 years 4.21 8.25 12.13 15.85 22.84 29.28
Figure 3
Impact of Firm Mortality on DCF Value (Morris, ‘‘ Life
and Death of Businesses,’’3)
15
Morris G. Danielson and Jean L. Heck, ‘‘The Perpetual Growth Model
and the Cost of Computational Efficiency: Rounding Errors or Wild
Distortions?’’ Financial Services Review 23 (2014), 189, 190–191.
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Adjusting for Corporate Mortality
The risk of corporate decline and mortality is not
reflected in customary capital asset pricing model
(CAPM) calculations, except to that the extent that they
are reflected in an industry risk premium or lumped into
an often-arbitrary company-specific risk premium.
16
In
Delaware, the primary jurisdiction for corporate litigation,
judges have been quite skeptical of company-specific risk
premiums that are not based on data. Vice Chancellor Leo
Strine, Jr. (now Chief Justice) explained the Court of
Chancery’s distrust of a company-specific risk premium
in determining weighted average cost of capital:
The calculation of a company specific risk is highly
subjective and often is justified as a way of taking into
account competitive and other factors that endanger the
subject company’s ability to achieve its projected cash flows.
In other words, it is often a back-door method of reducing
estimated cash flows rather than adjusting them directly. To
judges, the company specific risk premium often seems like
the device experts employ to bring their final results into line
with their clients’ objectives, when other valuation inputs
fail to do the trick [emphasis added].
17
Vice Chancellor Stephen Lamb commented in 2006,
‘‘[O]ur courts have not applied company-specific risk
premia without fact based evidence produced at trial on
which to base that discount.’’
18
Vice Chancellor (later
Chief Justice) Myron Steele had rejected a company-
specific risk premium in 1998, stating:
An investment specific premium may be appropriate to
account for risks not captured in the equity risk premium and
the small size premium. Unlike those two premia, which are
commonly determined by reference to the published results
of empirical research, a company specific risk premium
‘‘remains largely a matter of the analyst’s judgment, without
a commonly accepted set of empirical support evidence.’’
19
Chancellor William Chandler III wrote in 2010, ‘‘It is
important for any proposed company-specific risk premi-
um to be based on a specific financial analysis, so that the
Court can verify both the propriety of including the risk
premium and the appropriate level of the premium.’’
20
He
also distinguished between company-specific risk and
industry-specific risk:
Defendants offer three primary justifications for including a
company-specific risk premium: (1) the at-will termination
of supplier agreements that prevails throughout the whole-
sale alcohol distribution industry; (2) the competition
Sunbelt faces from specific players such as Southern Wine
& Spirits; and (3) the level of optimism contained in
Sunbelt’s management projections.
I conclude that none of these justifications merits inclusion
of a company-specific risk premium for Sunbelt. The first
and second justifications clearly relate to the industry as a
whole, rather than specifically to Sunbelt.
21
When corporate valuations are subject to scrutiny in
litigation, the quantification of mortality risk can be better
defended when backed by academic literature and, when
possible, with empirical data.
Modifying the Discount Rate
Sherrill Shaffer pointed out that since ‘‘most of the
value of a stream of discounted cash flows stems from the
distant future, . . . the correct adjustment for the risk of
failure may imply quite different values of equity than
those given by the standard model.’’
22
Since the risk of
corporate decline or failure exists in most valuations,
valuators need to make appropriate adjustments. Various
authors have begun to address the problem and have
proposed a variable, usually called ‘‘p,’’ for adjusting
valuations for the risk of business decline and failure.
In a 2006 article, Shaffer proposed adjusting the Gordon
growth formula for p, defined as the probability that ‘‘the
asset may irreversibly default (i.e., the issuing company
may fail) in any given year.’’
23
As to estimating p, he says:
The simplest way to estimate p is to use historical average
business failure rates, which are widely available . . . .
Recognizing that different industries sometimes exhibit very
different failure rates, sector-specific failure rates may be
more appropriate. . .. A more detailed and forward-looking
approach would involve statistical models predicting firm-
specific probabilities of failure, based on current financial
data for each firm and calibrated using historical linkages
between financial ratios and subsequent failure.
24
He solved his formula to determine the adjusted
discount rate:
25
16
Factors contributing to mortality risk, such as technological change,
competition, and obsolescence, are often industry-specific rather than
company-specific. When the valuator uses an industry risk premium
based on published data, these data are likely to be affected by mortality
risk.
17
Delaware Open MRI Radiology Associates v. Kessler, 898 A.2d 290,
339 (Del. Ch. 2006).
18
Gesoff v.IIC Industries, Inc., 902 A.2d 1130, 1158 (Del. Ch. 2006).
19
Hintmann v.Fred Weber, Inc., 1998 Del. Ch. LEXIS 26 (February 17,
1998) at *18–19, quoting Shannon P. Pratt, Robert F. Reilly, and Robert
P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely
Held Companies, 3rd ed. (New York: Irwin, 1996), 164.
20
In re Sunbelt Beverage Corp. Shareholder Litig., 2010 Del. Ch. LEXIS
1 (January 5, 2010) at *50.
21
Id. at *47.
22
Sherrill Shaffer, ‘‘Equity Duration and Convexity When Firms Can
Fail or Stagnate,’’ Financial Research Letters 4 (2007), 233, 235.
23
Sherrill Shaffer, ‘‘Corporate Failure and Equity Valuation,’’ Financial
Analysts Journal 62 (2006), 71, 73.
24
Shaffer, ‘‘Equity Duration and Convexity,’’ 239.
25
Shaffer, ‘‘Corporate Failure,’’ 74.
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Creative Destruction and the Perpetual Growth Assumption
R¼pð1þrÞ2
1þgpðrþgþ2Þ;
where R¼discount rate adjusted for p, r ¼discount rate,
and g ¼long-term growth rate.
Aswath Damodaran, also recognizing the issue, pre-
sented the following formula for adjusting enterprise value
for the risk of financial distress:
26
AV ¼PVð1pÞþDSV 3p;
where AV ¼present value adjusted for risk of financial
distress, PV ¼unadjusted present value based on DCF,
DSV ¼distressed sales value, and p ¼probability of
distress.
Damodaran posited that statistical techniques can be
applied to historical data to determine the probability of
distress as a function of observable variables. He noted
that factors such as high debt ratios and negative cash
flows increase the risk of failure, and commented that
mortality risk can be estimated utilizing bond ratings and
the historical relationship between ratings and de-
faults.
27
In a thoughtful 2012 article, Atanu Saha and Burton
Malkiel propose adjustments to terminal value calcula-
tions similar to Shaffer’s. They explained:
Because CAPM-based discount rates only account for
market risk, valuation models may greatly underestimate
the discount rate . . . in settings where the idiosyncratic risk
of the cash flows matters. This is especially so in cases
where there is a significant probability that the future stream
of cash flows may completely cease. This is a risk that the
CAPM ignores because that model assumes it is a risk that
can be diversified away. . . . [W]e believe that an additional
adjustment to the discount rate is warranted to account for
cash flow cessation probability, in settings where such a
possibility is not immaterial.
28
They developed a framework for calculating present
value adjusted for the risk of financial distress when free
cash flow has a constant probability of cessation at each
period:
29
AV ¼FCFð1þgÞð1pÞ
rgþpð1þgÞ:
Based on this formula:
30
R¼pþr
1p:
Saha and Malkiel developed a more complex formula
based on the assumption that the cessation risk declines as
the firm ages.
31
They based their estimates of the time-
varying discount rate on the observed attrition rate for
companies backed by venture capital or private equity
firms, utilizing separate data for information technology
firms and for all other companies.
32
The data they used
are summarized in Figure 4. Valuators should review
their article and consider the applicability the procedures
proposed by Saha and Malkiel to their specific valuations.
Quantifying Mortality Risk
The general practice of assuming a constant perpetual
growth rate for calculating terminal value needs to be
reexamined. Adjustments for firm mortality or for the risk
of decelerating growth must be considered. Although the
quantitative impact may be de minimis for companies
with a low mortality risk, the risk for young companies,
particularly in biotech and high-tech companies, is clearly
material.
Figure 4
Observed Attrition Rate for Non-IT and IT Firms, 1987–
1999 (Saha and Malkiel, ‘‘Valuation of Cash Flows with
Time-Varying Cessation Risk,’’11)
26
Aswath Damodaran, Investment Valuation, 3rd ed. (New York: Wiley,
2012), 319–320.
27
Ibid., 320.
28
Atanu Saha and Burton K. Malkiel, ‘‘Valuation of Cash Flows with
Time-Varying Cessation Risk,’’ Journal of Business Valuation and
Economic Loss Analysis 7 (2012) , Art. 3, 1.
29
Ibid. The notation is modified to conform to Shaffer’s notation.
30
Ibid.
31
Ibid., 5–6.
32
Ibid., 9–14.
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Venture capitalists customarily account for the sub-
stantial possibility that a start-up company may not
succeed by using discount rates of 35% or more. These
high discount rates used by venture capital investors
clearly include mortality risk. However, mortality risk is
seldom included as a quantified factor when discount
rates are determined using CAPM or the build-up method.
The valuation community—and the academic commu-
nity—should consider how to quantify the risks not only
of mortality but also of declining (or negative) long-term
growth. How can these risks be reflected in higher
discount rates and/or lower long-term growth rates?
Morris noted in 2009, ‘‘There are no generally accepted
mortality tables for businesses.’’
33
He discussed several
studies, but these (which includes academic studies for
disciplines other than finance) are of limited use. His
industry table based on SBA data is dominated by very
small companies, and other data that he cited are too
granular, focusing on individual plants rather than
companies as a whole.
Subsequently, a useful mortality table for U.S. public
companies was constructed by Bhattacharya, Borisov,
and Yu.
34
They reviewed all U.S publicly traded firms
from 1985 through 2006. Since their data were based on
IPOs, most of the companies reviewed began the
observation period with a material cash infusion, limiting
the usefulness of the study. They observed:
We find that mortality rates initially increase, peaking at 3
years after a firm goes public, and then decrease with age. In
contrast to the stylized fact noted in the industrial
organization literature that survival risk decreases as a firm
ages, our results indicate that U.S. public firms need to
survive up to the critical age of 3 years after the initial public
offering (IPO) before their survival risk starts diminishing.
35
Developing Empirical Data
It is necessary to develop appropriate risk premiums
that can be applied for corporate valuations to reduce
valuators’ reliance on their subjective judgment. This will
require substantial further empirical research into firm
decline and mortality. Corporate mortality analyses often
include acquisitions of healthy companies. When data for
businesses that are continuing to grow at the time they are
acquired are mixed with corporate mortality data for
declining companies, the results are distorted. If the data
for determining the risk of corporate mortality is to be
useful, it is vital that acquisitions of healthy firms be
distinguished from acquisitions of troubled businesses.
Studies of corporate decline and mortality should focus
on companies that suffer material declines because of
poor performance or whose existence terminates. The
studies need to analyze the data by industry and should
measure the effect of size on mortality. Analyses of size
should consider, inter alia, such variables as revenues,
number of employees, and the value of tangible assets.
Another factor that would might be expected to affect a
company’s mortality risk is R&D, which should serve to
mitigate the risk of obsolescence. It would be useful to
determine the correlation between companies’ R&D
expenditures and their longevity.
A company-specific factor that valuators should
consider is the impact of financial strength on corporate
mortality. For this purpose, studies of financial distress as
a function of credit ratings would be useful. Unlike most
factors now being considered in estimating company-
specific risk, credit risk can be supported by empirical
data published on a continuing basis by widely accepted
sources.
Conclusion
The assumption of perpetual growth ignores the
consequences of creative destruction and disruptive
innovation and the obvious fact that companies decline
and often fail. Although the available data on corporate
mortality are limited, these data should not be ignored.
Failing to consider this factor may result in material
overvaluations. Further research is needed to provide
valuators with better data for quantifying corporate
mortality, thereby reducing reliance on subjective judg-
ment.
33
Morris, ‘‘Life and Death of Businesses,’’ 2.
34
Utpal Bhattacharya, Alexander Borisov and Xiaoyun Yu, ‘‘Firm
Mortality and Natal Financial Care,’’ Journal of Financial and
Quantitative Analysis 50 (2015), 88. Mortality tables have also been
published for Portuguese companies (Pedro Nogueira Reis and Ma´rio
Gomes Augusto,’’ What Is a Firm’s Life Expectancy? Empirical
Evidence in the Context of Portuguese Companies,’’ Journal of Business
Valuation and Economic Loss Analysis 10 [2015], 75) and for enterprises
in the Hunan region of China (Xiaohong Chen, Yu Cao, and Fuqiang
Wang, ‘‘A Life Cycle Analysis of Hunan’s Enterprises and Their
Determinants,’’ China Economic Review 21 [2010], 481).
35
Bhattacharya et al., ‘‘Firm Mortality and Natal Financial Care,’’ 62.
Business Valuation Review
TM
— Winter 2018 Page 157
Creative Destruction and the Perpetual Growth Assumption
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  • Hintmann V. Fred
  • Inc Weber
  • P Quoting Shannon
  • Robert F Pratt
  • Robert P Reilly
  • Schweihs
Hintmann v. Fred Weber, Inc., 1998 Del. Ch. LEXIS 26 (February 17, 1998) at *18-19, quoting Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd ed. (New York: Irwin, 1996), 164.
Equity Duration and Convexity
  • Shaffer
Shaffer, ''Equity Duration and Convexity,'' 239.
Life and Death of Businesses
  • Morris
Morris, ''Life and Death of Businesses,'' 2.
Journal of Business Valuation and Economic Loss Analysis 10 [2015], 75) and for enterprises in the Hunan region of China (Xiaohong Chen, Yu Cao, and Fuqiang Wang
  • Utpal Bhattacharya
  • Alexander Borisov
  • Xiaoyun Yu
Utpal Bhattacharya, Alexander Borisov and Xiaoyun Yu, ''Firm Mortality and Natal Financial Care,'' Journal of Financial and Quantitative Analysis 50 (2015), 88. Mortality tables have also been published for Portuguese companies (Pedro Nogueira Reis and Mário Gomes Augusto,'' What Is a Firm's Life Expectancy? Empirical Evidence in the Context of Portuguese Companies,'' Journal of Business Valuation and Economic Loss Analysis 10 [2015], 75) and for enterprises in the Hunan region of China (Xiaohong Chen, Yu Cao, and Fuqiang Wang, ''A Life Cycle Analysis of Hunan's Enterprises and Their Determinants,'' China Economic Review 21 [2010], 481).