Three Stage Growth Model
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Transcript of Three Stage Growth Model
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Three stage Growth
Model
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Discounted Cash Flow Method
Valuing a firm using the discounted cash
flow approach calls for forecasting cash
flows over an indefinite period of timefor an entity that is expected to grow.
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VALUE OF THE FIRM
Present value of cash flow during an explicit
forecast period
+
Present value of cash flow after the explicit
forecast period.
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DCF APPROACH
DCF model deals with the year to year
forecasts which permits any kind of variation
in any item from year to year but when such
detailed forecasts are not available than
simplified version of DCF approach are used :
Two stage growth model
Three stage growth model
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TWO STAGE GROWTH MODEL
Value of the firm =
Present value of the FCF during the high growth phase
+
Present value of the terminal value.
In corporate finance, free cash flow (FCF) is cash
flowavailable for distribution among all the securitiesholders of an organization. They include equity
holders, debt holders, preferred stock holders,
convertible securityholders, and so on.
http://en.wikipedia.org/wiki/Corporate_financehttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Convertible_securityhttp://en.wikipedia.org/wiki/Convertible_securityhttp://en.wikipedia.org/wiki/Convertible_securityhttp://en.wikipedia.org/wiki/Convertible_securityhttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Preferred_stockhttp://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Cash_flowhttp://en.wikipedia.org/wiki/Corporate_financehttp://en.wikipedia.org/wiki/Corporate_financehttp://en.wikipedia.org/wiki/Corporate_finance -
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THREE STAGE GROWTH
MODEL
It assumes that :
1. The firm will enjoy a high growth rate for thecertain period usually 3 to 7 years.
2. The higher growth period will be followedby transition period during which growth ratewill decline in linear increment.
3. The transition period will be followed by astable growth forever.
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VALUE OF THE FIRM
Present Value of FCF during the high growthperiod
+
Present Value of FCF during the transitionperiod
+
Present Value of the terminal period.
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Example
Assume the following for IBM:
Required rate of return is 12%
Current dividend is $0.55 Growth rate and duration for phase one are 7.5%
for two years
Growth rate and duration for phase two are 13.5%
for the next four years
Growth rate in phase four is 11.25% forever
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Time Value Calculation Dtor Vt
Present values
Dt/(1.12)tor
Vt/(1.12)t
1 D1 0.55(1.075) 0.5913 0.5279
2 D2 0.55(1.075)2 0.6356 0.5067
3 D3 0.55(1.075)2(1.135) 0.7214 0.5135
4 D4 0.55(1.075)2(1.135)
20.8188 0.5204
5 D5 0.55(1.075)2(1.135)
3 0.9293 0.5273
6 D6 0.55(1.075)2(1.135)
4 1.0548 0.5344
6 V6 0.55(1.075)2(1.135)4(1.1125)/(.12.1125) 156.4620 79.2685
Total 82.3897
Terminal Value = Cash Flow/WACC- G
WACC : Weighted average cost of capital
G : growth rate.
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Strengths of three stage growth
model
Can accommodate a variety of patterns offuture dividend streams.
Even though they may not replicate the future
dividends exactly, they can be a usefulapproximation.
The expected rates of return can be imputed by
finding the discount rate that equates thepresent value of the dividend stream to thecurrent stock price.
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Using a model forces the analyst to specify
assumptions (rather than simply using
subjective assessments). This allows analysts
to use common assumptions, to understand thereasons for differing valuations when they
occur, and to react to changing market
conditions in a systematic manner
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Thank you
