Two-Stage Free Cash Flow Models
When Facebook initiated its first IPO in May 2012, it wasn't hard to see Facebook's enormous growth potential, with monthly user growth averaging over 3% at times. Five years later, Facebook had slowly developed into a more mature company, with user growth averaging closer to 0.75% per month.
When it comes to valuation models that try to capture that kind of Facebook-type growth, what kind of model do you think might be a good choice?
No.
A dividend discount model is appropriate for a mature company, not a growth company.
There are two types of two-stage models. The first model keeps the growth rate constant in Stage 1 and then drops it immediately in Stage 2 to the consistent long-term rate. The second type of model is basically the H-model for discounted dividend valuation, in which case Stage 1 growth rates decline to the long-term rate in Stage 2 over time.
Not so.
A single-stage model would only capture the growth of one period, but Facebook's growth is changing over time.
The second model might be a good choice for a company whose growth has declined over time. How that growth is measured is crucial to an accurate valuation of a model, especially for young startups.
What type of growth measure might apply to, for example, a young tech startup?
No.
As a startup, a company wouldn't have a great feel for how income would change over the coming periods, so the net income growth rate wouldn't be the best choice.
No, actually.
Free cash flow growth wouldn't be a great initial rate because the company is just starting out. Projecting that growth rate over time would be difficult.
The formula for the two-stage FCFF valuation model is a fun one.
$$\displaystyle \mbox{Firm Value} = \sum_{t=1}^{n} \frac{FCFF_t}{(1+\ WACC)^t} + \frac{FCFF_{n+1}}{(WACC - g)}\frac{1}{(1+\ WACC)^n}$$
The terminal value is represented by
$$\displaystyle \frac{FCFF_{n+1}}{WACC-g}$$.
And as you can imagine, the FCFE two-stage equation looks very similar. Just substitute the required rate of return for WACC.
$$\displaystyle \mbox{Equity Value} = \sum_{t=1}^{n} \frac{FCFE_t}{(1+\ r)^t} + \frac{FCFE_{n+1}}{(r - g)}\frac{1}{(1+\ r)^n}$$
So the terminal value of FCFE is
$$\displaystyle \frac{FCFE_{n+1}}{r-g}$$.
And this terminal value can really impact the total valuation of a company.
Why do you think that's the case?
No.
The initial growth is important, but the terminal value represents more than just the initial phase.
Not quite.
The terminal value doesn't capture the startup value. It represents more than just one point in time.
Yes!
The terminal value is extremely important because it typically represents a large portion of the total value, so it would capture the long-term growth of the mature company.
Whatever the approach, a two-stage model would be great for valuing startups because it would capture the high investment phase of initial growth to the transition period of the long-term sustainable growth rate.
To sum up:
[[summary]]
That's it!
A model with multiple growth rates would be perfect. That's called a __two-stage model__. It would be an excellent model to use because it would capture a company's initial rapid growth, its transition to a mature company, and its long-run sustainable growth rate.
Exactly!
The monthly active user growth rate would be a great choice to highlight the company's overall growth over time because active users would set the rates that the young tech startup could charge.
Really, though, the growth rate used in the free cash flow models can be any number of different variables; it just depends upon the company.
One based on dividends
One based on multiple stages of growth
One based on a single consistent growth pattern
Net income growth
Free cash flow growth
Monthly active user growth
It captures the initial growth
It represents the startup value
It represents a large portion of the total value
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