1) Choose a Model (One-Stage vs Two-Stage)
Use the one-stage model for a mature firm with a stable growth rate, below or close to the growth rate of the economy. A two-stage model is more appropriate for firms still in their growth stage. For the two-stage model, you will need to specify the length of the first stage (in years) and the growth rate during that period.Â
2) Initial Cash Flow ($)
This is the cash flow available to equity shareholders after cash flows to all non-equity claims (i.e. debt) and capital expenditures have been paid. You can calculate the free cash flow by subtracting capital expenditures from operating cash flows. Both can be found on the Cash Flow Statement. Cash flows can be volatile, so make sure to normalize them first. For example, you can normalize cash flows by taking their average over the last 3-5 years.
3) Discount Rate (%)
The discount rate, often called the required rate of return, is the minimum return an investor will accept for owning a company’s stock. Inflation and the return available on other investments should be factored into the calculation of discount rates. You can split the discount rate into two components: risk-free rate and risk premium. The risk-free rate is the yield on government bonds, while the risk premium is the additional compensation above the risk-free rate you require to invest in a risky asset. For simplicity and ease of comparison, we use a 9%-10% required rate of return.
4) Terminal Growth Rate (%)
This is the growth rate at which the company is expected to grow its free cash flow into perpetuity. The terminal growth rate shouldn’t be higher than the expected nominal growth in the economy in which the company operates. In the United States, it’s reasonable to assume a nominal growth of 4-5% (2% real growth and 2-3% inflation). Assuming a higher terminal growth than the expected nominal economic growth would imply that the company will become larger than the size of the economy, which is not a realistic assumption. You can assume a lower growth than that, but note that assuming a growth rate lower than the expected rate of inflation (2-3%) would imply that the company will contract in real terms.
The model is very sensitive to the inputs. Don’t think of the model to be producing precise intrinsic value estimates, but use it for directional guidance in your valuation work.
