Not all companies can maintain their current levels of net operating profit after tax. For example, DVD, game, and video rental businesses and wired telecommunications carriers face secular decline. In these instances, you need to modify the steady-state value with a variation of the Gordon growth model:
Steady-state value = Net operating profit after tax / Cost of capital
Modified steady-state value = Net operating profit after tax (1+ growth) / (Cost of capital – growth)
Take as an example a company that has $1,000 in NOPAT and an 8 percent cost of capital. The steady-state value is $12,500 ($1,000/.08). Let’s now assume that the company’s profit will decline 10 percent per year in perpetuity. We add a negative value for growth in the numerator, which reduces NOPAT. We also subtract a negative in the denominator, which increases the discount rate. Modified steady-state value = $5,000
Assuming this rate of decline is accurate and the market prices it properly, the steady-state multiple is 5.0 times ($5,000/$1,000).
BlueMountain Investment Research, September 2018