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Growth Appreciation Period (GAP)

Monday, June 24th, 2013

The Growth Appreciation Period is the number of years that a business is expected to earn an ROIC greater than WACC on new investments.

GAP is the amount of time a business can grow its economic earnings. After the GAP, it is assumed that incremental investments by the business earn ROIC equal to WACC or the net present value of all investments equal zero. Warren Buffett refers to GAP as the moat around a business’ castle. It is also known as the CAP (Competitive Advantage Period) and the forecast growth horizon.

Our dynamic DCF model calculates share prices for attributable to multiple GAP scenarios. For example, the value of the company with a twenty-year forecast growth horizon assumes the company will enjoy a twenty-year GAP. Without a model that encompasses this long-term approach, investors are unable to assess the complete expectations embedded in any asset price.

Market-Implied GAP

The market-implied GAP is the number of years that a company’s stock market price implies it will earn ROIC greater than WACC on incremental investments. Provided that the estimates entered on the forecast page are based on market consensus projections, the market-implied GAP represents the forecast horizon needed in a DCF model to arrive at a value equal to the current market price.

How GAP Is Used in our Discounted Cash Flow (DCF) Model

The key difference between our DCF and others is that we calculate the value attributable to equity shareholders over multiple time periods, not just 5 or 10 years. In addition, our yearly calculations represent different GAPs because they are based on a Terminal Value that assumes the company generates no future incremental profits. To be specific, our Terminal Value for each annual calculation is a perpetuity calculation that assumes no future growth after each GAP. The formula is NOPATt+1 divided by WACC. Using a Terminal Value that assumes no future profit growth enables our DCF model to calculate the specific value of companies implied by each Growth Appreciation Period.

See Figure 1 for a graphic representation of how our model’s dynamic discounted cash flow analysis calculates the value of a business and the attendant value available to shareholders for multiple Growth Appreciation Periods. This chart shows how the value of the company analyzed in this example rises as its Growth Appreciation Period increases. The ‘Market Implied GAP’ equals the Market-Implied Growth Appreciation Period implied by the current market price. Our model calculates the ‘Market Implied GAP’ by matching the current stock price with the year that the DCF value matches that of the current stock price. For example, the ‘Market Implied GAP’ for the company in Figure 3 is 16 years. Our model can also calculate the GAP implied for target prices as well as any other stock prices no matter how great or small they may be. The analysis in Figure 3 shows DCF values for only 35 years though the model values companies for 100 years into the future.

Figure 1: How We Use A DCF model To Determine GAP

Figure 3

Source: New Constructs, LLC

Figure 2 shows the DCF  info summarized on the Company Model Decision Page.

Figure 2: The Valuation Matrix

Figure 4

Source: New Constructs, LLC

Figure 3, below, presents a copy of the DCF model used to generate the values in Figure 2.

Figure 3 also shows how our DCF model calculates values for multiple forecast horizons or Growth Appreciation Periods. These values provide the data needed to generate a chart like the one in Figure 2 above and like the valuation matrix as presented on the Company Model Decision Page. Note the highlighted sections in Figure 4 and how they jibe exactly with the Revenue CAGRs, Economic Earnings Margin, and GAPs presented in Figures 2 and 3.

Figure 3: Sample Dynamic Discounted Cash Flow Model for Sample Company

Figure 5

Source: New Constructs, LLC

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  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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