A company is incorporated as per the corporate laws of the land. When incorporated, it becomes a separate legal entity by itself and continues to function as a separate legal entity unless it is intentionally shut down in accordance with the corporate laws of the land. Since the company is a separate entity and lives on until it is shut down, it theoretically has an infinite lifespan. The owners and managers of the company may come and go but the company theoretically can live forever. How many years do we need to forecast financials?
This poses a problem for us: Since we agree that the value of a business is the sum of the present values of all future cash flows, the fact that a company can live on forever presents a problem. How many years of cash flow can we project with reasonable accuracy? Even predicting 3 to 5 years of cash flow is a challenge. Predicting anything beyond 3 to 5 years is difficult. We overcome this problem by breaking up the cash flow projections into two or three stages. This is why DCF models are sometimes referred to as two-stage or three-stage models.
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