7.11 Three Important Concepts: Summary  

Assessing the intrinsic value of a stock using the Free Cash Flow methods requires estimating three important concepts:

1.  The dividends a stock could pay which is referred to as it's free cash flow to equity.

2.  The growth behavior that is assumed to govern the generation of future dividends

3.  The appropriate discount rate which is referred to as the stock's cost of equity capital.

In the previous sections we developed the first concept.  However, to extend this to future estimates of free cash flow requires forecasting future financial statements.  This usually starts with assessing growth.  Assessing growth usually starts with the top line, sales revenue and then an analyst projects future financial statements from this assessment.  This results, in forecasts of future earnings which are widely available on the web.  For example, forecasts are usually published in terms of 1-year ahead, 2-years ahead and 5-years ahead.  By working with these forecasts you can forecast future free cash flows using one of the techniques described earlier. 

In the most common model we consider growth behavior in two stages as discussed in the previous chapter.  In stage 1 we will refer to the growth behavior as “abnormal” only because stage 1 growth is not subject to an upper bound of economy wide growth rates.  That is, it is not unusual for stage 1 growth rates to be larger than the economy wide growth upper bound and sometimes very much larger.   In stage 2 we refer to growth as normal growth and this number cannot exceed the growth rate for the economy as a whole.  The reason being that when applied in a valuation model for a going concern, normal growth is applied in perpetuity.  As a result, normal growth cannot exceed economy wide growth or the contradictory implication is that the firm ultimately grows larger than the economy as a whole --- a contradiction!