whobelievethattheonlyassumptionconsistentwith stable
growthistoassumenoexcessreturns;thereturnoncapitalis
set equalto thecostof capital.While, inprinciple,excess
returnsinperpetuityarenotfeasible,itisdifficultinpractice
toassumethatfirmswillsuddenlylosethecapacitytoearn
excess returns. Since entire industries often earn excess
returnsoverlongperiods,assumingafirm’sreturnsonequity
and capital will movetoward industry averages will yield
more reasonable estimates of value for many companies.
Debt Ratios and Costs of Debt
High-growthfirms tendto uselessdebtthanstable-growth
firms.Asfirmsmature,theirdebtcapacityincreases.When
valuingfirms,thiswillresultinchangesinthedebtratiothat
weusetocomputethecostofcapital.Whenvaluingequity,
changingthedebtratiowillchangeboththecost ofequity
andtheexpectedcashflows.Thequestionofwhetherthedebt
ratioforafirmshouldbemovedtowardamoresustainable
levelinstablegrowthcannotbeansweredwithoutlookingat
theincumbentmanagers’viewsondebtandhowmuchpower
stockholdershaveinthesefirms.Ifmanagersarewillingto
changetheirdebtratioandstockholdersretainsomepower,it
isreasonable to assume thatthedebt ratiowillmoveto a
higherlevel instablegrowth;ifnot,itissafer toleavethe
debt ratio at existing levels.
As earningsand cashflowsincrease, theperceiveddefault
risk in thefirm willalso change. Afirm thatis currently
losing$10milliononrevenuesof$100millionmayberated
B,butitsratingshouldbemuchbetterifyourforecastsof$10
billioninrevenuesand$1billioninoperatingincomecometo
fruition. In fact, internal consistency requires that you