The most common approaches to forecasting them are the constant growth model, the two-stage model, and the three-stage or n-stage model.The first one assumes that the firm has already reached a steady state phase, therefore the value of the firm is equal to the present value of a constant growth perpetuity. It is a very simple model that can be used for firms with constant streams of cash flows which operate in mature industries. The two-stage model is intended to value a company which is expected to grow much faster than a stable firm in the initial period and at a stable rate after that. The three stage or n-stage model is designed to value small companies with growing market. It assumes that the company will grow initially at a high grow rates, then it will follow a transitional period where the growth rate declines and finally a steady state period where growth is …show more content…
Since different studies have revealed that neither historical growth nor management forecasts are good predictors of future growth, some authors (Damodaran 2011) suggest to rely on fundamental analysis. The growth rate is a function of the percentage of the reinvested earnings and the return earnings on that investment.In order to understand how the company's value is affected by a change in the underlying assumptions, a sensitivity analysis is usually conducted. For instance, starting from the base scenario it is possible to determine a optimistic scenario and a pessimistic one, in order to define the two limits of where in between the fair value of the company should be.
The Discount rate
The discount rate, which is the instrument for adjusting for risk, is one of the most important inputs in the DCF model. Small changes in the discount rate will result in large changes in the firm value. For the firm valuation the appropriate discount rate is the average cost of capital while for the equity valuation we will have to use the cost of equity.
The cost of equity represents the opportunity cost of investing in the firm. The most common method to determine it is the CAPM, whose formula