Beyond the net assets owned by a business today, intrinsic value is driven by current and especially future earnings. For that reason, projecting future earnings growth is vital to determining intrinsic value. The following sections explain how to examine growth assumptions more closely.
True intrinsic value is the total of all expected future returns: this year, next year, 5, 10, 20, 40, 80 years from now. How can you possibly project a companys return when part of it includes something that happens 77 years from now? Its hard enough to project next years returns. Answer: by taking it in stages:
First stage: Typically the first stage is ten years, although in some analyses it may be more or less. Near – term growth is by nature easier to model, and as a result of the discounting process, it contributes more toward the final result anyway. For these reasons, intrinsic value models are set up to specifically value a first stage in detail, year – by – year. The first stage is generally assumed to have a higher growth rate and a lower discount rate than the second stage.Second stage: Second – stage returns are harder than first – stage to project with any degree of accuracy, so intrinsic value models use one of two assumptions to estimate what is known as continuing value.
Indefinite life: The indefinite life model assumes ongoing returns and uses a mathematical formula to project returns over an indefinite period of time.
Acquisition: A convenient way to bypass mathematical approximations is to assume that someone will come along and buy your business after the first stage at a reasonable valuation. Returns include all future payouts, including lump sums, so this method works too, so long as resale value is projected reasonably.
Each stage of a business life has a growth rate and discount rate applicable to that stage. To run a model, you need a base, first – and second – stage growth rates, and first – and second – stage discount rates. You calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalized formula, either indefinite life or acquisition – based, is applied to the second stage. The value attributed to the second stage is called continuing value.
