We agree that the value of a business when doing Discounted Cash Flow (DCF) valuation is the sum of the present values of ALL future cash flows. How long do we mean when we refer to the ‘future’? How many years does the company live? the fact that a company can live on forever presents a problem.
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 (shareholders) and managers (CEO & board of directors) of the company may come and go but the company theoretically can live forever.
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.
In a two-stage model, the first stage is the near term and often referred to as the forecast period. This can be the next three, five or ten years. We will forecast the operating performance of the business in detail and arrive at the cash flows of the business for each year of this period.
The level of confidence in predicting the detailed cash flows usually determines if we forecast three, five or ten years for the first stage in a DCF valuation model. A mature company with a long history usually enables us to predict cash flows with more accuracy. A start up in a newly developed market will have less history or comparable companies to study and therefore will leave us with less confidence to predict cash flows a few years forward.
In a two-stage model, the second stage is the entire period after the first stage. This stage is theoretically never-ending because the life of the company can go on forever or up to infinity! Finding the present value of the cash flows of this period would have posed a challenge if it weren’t for brilliant mathematicians we are fortunate to have. These mathematicians have provided us formulas to compute the present values of perpetual streams of cash flows. We assume that cash flows in the second stage, also called the terminal or horizon stage, are constant or grow at a low constant rate. We will address how to compute the present values of this stage here.
In today’s technology and internet-enabled world, some rapidly growing companies grow at unearthly rates of 50%, 100% and even 200% a year during the first few years. These tremendous growth rates are not sustainable for long periods. These high growth rates usually drop off in a few years and reach more earthly rates of 10%, 15%, 20% or even 30% which are still fantastic growth rates for most companies. Eventually, even these companies become mature, face competition and encounter obstacles and over time slow down to grow at historical rates.
Therefore, if you are trying to value a rapidly growing company, a three-stage or even a multistage model is the way to go. The first stage may have the companies grow at unearthly speeds of 50%, 100% or 200% a year. The second stage could have the companies grow at more earthly rates of 15%, 20% or even 30%. The third stage could have the growth rates decline steadily to terminal or horizon stage growth rates. We assume that cash flows in the final and last stage, also called the terminal or horizon stage, are constant or grow at a small but constant rate. We will address how to compute the present values of this stage in the present values formulas sheet.