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Three Stage Growth Model

The three stage growth model is a simplified version of the discounted cash flow approach that is used to value a firm when detailed year-to-year forecasts are not available. It assumes three phases of growth: 1) a high growth period lasting 3-7 years, 2) a transition period where the growth rate declines linearly, and 3) a stable growth period lasting forever. The value of the firm is calculated as the present value of free cash flows during the high growth period, plus the present value during the transition period, plus the present value of the terminal period. An example is provided to illustrate the calculation of a firm's value using the three stage growth model.

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Navleen Kaur
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1K views12 pages

Three Stage Growth Model

The three stage growth model is a simplified version of the discounted cash flow approach that is used to value a firm when detailed year-to-year forecasts are not available. It assumes three phases of growth: 1) a high growth period lasting 3-7 years, 2) a transition period where the growth rate declines linearly, and 3) a stable growth period lasting forever. The value of the firm is calculated as the present value of free cash flows during the high growth period, plus the present value during the transition period, plus the present value of the terminal period. An example is provided to illustrate the calculation of a firm's value using the three stage growth model.

Uploaded by

Navleen Kaur
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Three stage Growth

Model


Discounted Cash Flow Method
Valuing a firm using the discounted cash
flow approach calls for forecasting cash
flows over an indefinite period of time
for an entity that is expected to grow.


VALUE OF THE FIRM

Present value of cash flow during an explicit
forecast period
+
Present value of cash flow after the explicit
forecast period.
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
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
flow available for distribution among all the securities
holders of an organization. They include equity
holders, debt holders, preferred stock holders,
convertible security holders, and so on.
THREE STAGE GROWTH
MODEL
It assumes that :
1. The firm will enjoy a high growth rate for the
certain period usually 3 to 7 years.
2. The higher growth period will be followed
by transition period during which growth rate
will decline in linear increment.
3. The transition period will be followed by a
stable growth forever.
VALUE OF THE FIRM

Present Value of FCF during the high growth
period
+
Present Value of FCF during the transition
period
+
Present Value of the terminal period.
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


Time

Value

Calculation

D
t
or V
t

Present values
D
t
/(1.12)
t
or
V
t
/(1.12)
t

1 D
1
0.55(1.075) 0.5913 0.5279
2 D
2
0.55(1.075)
2
0.6356 0.5067
3 D
3
0.55(1.075)
2
(1.135) 0.7214 0.5135
4 D
4
0.55(1.075)
2
(1.135)
2
0.8188 0.5204
5 D
5
0.55(1.075)
2
(1.135)
3
0.9293 0.5273
6 D
6
0.55(1.075)
2
(1.135)
4
1.0548 0.5344
6 V
6
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.
Strengths of three stage growth
model
Can accommodate a variety of patterns of
future dividend streams.
Even though they may not replicate the future
dividends exactly, they can be a useful
approximation.
The expected rates of return can be imputed by
finding the discount rate that equates the
present value of the dividend stream to the
current stock price.


Using a model forces the analyst to specify
assumptions (rather than simply using
subjective assessments). This allows analysts
to use common assumptions, to understand the
reasons for differing valuations when they
occur, and to react to changing market
conditions in a systematic manner
Thank you

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