Intrinsic value is driven by current and especially future earnings. Projecting future growth in these earnings is vital to determining intrinsic value.
Near-term growth is by nature easier to model, and as a result of the discounting process, they contribute more towards the final result anyway. So intrinsic value models are set up to specifically value a first stage in detail, year-by-year. Typically, the first stage is 10 years, although in some analyses it may be more or less.
More often than not, the first stage is assumed to have a higher growth rate and a lower discount rate than the second stage.
The second stage covers the more nebulous period of business life beyond the first stage. Second-stage returns are harder to project accurately, so intrinsic value models use one of two assumptions to estimate what’s 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 and assign a value to those returns.
- Acquisition: Want a convenient way to bypass mathematical approximations? 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. One growth rate and one discount rate is applied to the first stage, and another growth and discount rate to the second. Then, you calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalised formula, either indefinite life or acquisition-based, is applied to the second stage. The value attributed to the second stage is called continuing value.