Two-stage (multistage) growth models
Grow the latest dividend or free cash flow to equity at the short-term rate g_s for n periods and discount each. At period n, value everything after it with the constant growth formula, IV_{t+n} = CF_{t+n+1} ÷ (r_e − g_l), and discount that n periods. Add the two parts.
Before this: Constant growth models, implied growth and the sustainable growth rate
On the exam
- Calculate and interpret the intrinsic value of an equity security based on present value models that assume constant cash flow growth or multistage cash flow growth
Calculate and interpret intrinsic value with a two-stage (multistage) growth model for dividends or free cash flow to equity (FCFE). Expect the value from a growth path, the first cash flow of the stable stage, the period over which the terminal value is discounted, a per-share value from total FCFE, and how the value moves with the fast-growth period, g_l and r_e.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
When do you need more than one growth rate?
A multistage growth model fits when expected cash flow growth changes over time, for example a company expanding fast into new markets before slowing to a stable rate. The fast stage can use one higher rate for periods or a different rate for each year; once growth is stable, a terminal value captures everything after. The first stage can also be below trend, a weak spell before a recovery. Present value models built on past cash flows are not useful for startups with little revenue and losses; they work from the growth stage on.
The simplest case is the two-stage growth model . It gives the company two growth rates: a short-term growth rate g_s for a finite number of periods , and a long-term growth rate g_l forever after. It works for dividends, and the same method works for free cash flow to equity (FCFE), which the formulas below use.
Revenue growth is not cash flow growth, and the difference is the caution of this section (revenue growth versus cash flow growth ). A budget gym chain can grow membership fees 15% a year while its FCFE falls, because every new gym it opens eats cash. Grow the cash flow you discount, not the sales.
- Constant growth Use it already stable; mature
- Two-stage Use it a spell of above- or below-trend growth, then stable
- Typical case advantage that fades as rivals arrive
- Also fits a temporary slump before recovery
-
- A rate for each year Know the idea path forecast year by year
- No growth model Know the idea startups without revenue; transformational change
The method has two parts. Forecast the cash flows of the fast stage one at a time. Then collapse everything after that into one number at period , the terminal value at the end of the fast stage , using the constant growth formula.
Here is the intrinsic value today, is the free cash flow to equity just earned (for a share paying dividends, use ), is the required return on equity and is the value at period .
The constant growth formula values cash flows starting one period after the date it is applied. So , applied at period , values cash flows from period on, and it needs the first cash flow of the stable stage . The terminal value is a value at period , so it is discounted periods, the same as the period- cash flow.
A company's free cash flow to equity for the year just ended was 18.00 million. It will grow 15.00% a year for 4 years and 3.00% a year thereafter. The required return on equity is 10.00%. The equity value, in millions, is closest to:
PV of cash flows 80.56 + PV of the terminal value (463.24 ÷ 1.1^4) 316.40 = 396.96
Equity value (millions)396.96
- 1.15y^x4×18=cash flow in year 4
- ×1.03÷(0.1−0.03)=terminal value, 463.2368
- CF2NDCLR WORK
- 0ENTER↓20.7ENTER↓↓23.805ENTER↓↓27.37575ENTER↓↓494.718911ENTERthe last flow is the year 4 cash flow + the terminal value
- NPV10ENTER↓CPT396.9592
y^x power · CF cash flow worksheet · 2ND second function (the shifted label above a key) · CLR WORK clear the worksheet · ENTER enter (on the HP, puts the number on the stack) · NPV net present value · CPT compute
- 1.15ENTER4y^x18×cash flow in year 4
- 1.03×0.1ENTER0.03−÷terminal value, 463.2368
- fCLEAR REG
- 0gCF020.7gCFj23.805gCFj27.37575gCFj494.718911gCFjthe last flow is the year 4 cash flow + the terminal value
- 10i
- fNPV396.9592
ENTER enter (on the HP, puts the number on the stack) · y^x power · f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value
Try this 0 of 3
- Turn on any two traps and compare with the right value
- Push the terminal value's share of intrinsic value above 90%
- Stretch the fast stage to 8 periods
| Period | Cash flow | PV |
|---|---|---|
| 1 | Dₜ₊₁ 1.38 | 1.2545 |
| 2 | Dₜ₊₂ 1.587 | 1.3116 |
| 3 | Dₜ₊₃ 1.825 | 1.3712 |
| 3 | IVₜ₊₃ 38.326 | 28.7949 |
| IVₜ | 32.73 |
Show working
Fast stage: Dₜ₊₁ = 1.38, Dₜ₊₂ = 1.587, Dₜ₊₃ = 1.825 (each × 1.15).
Dₜ₊₄ = Dₜ₊₃ × (1 + gₗ) = 1.825 × 1.05 = 1.9163
IVₜ₊₃ = Dₜ₊₄ ÷ (rₑ − gₗ) = 1.9163 ÷ (0.1 − 0.05) = 38.326
PV of the fast stage = 1.38 ÷ 1.1 + 1.587 ÷ 1.1² + 1.825 ÷ 1.1³ = 3.9373
PV of IVₜ₊₃ = 38.326 ÷ 1.1³ = 28.7949 (discounted 3 periods, not 4)
IVₜ = 3.9373 + 28.7949 = USD 32.73
- 1.82505×1.05÷(0.1−0.05)=IVₜ₊₃ = 38.326
- CF2NDCLR WORK
- 0ENTER↓CF0
- 1.38ENTER↓↓C01
- 1.587ENTER↓↓C02
- 40.1511ENTER↓↓C03 = Dₜ₊₃ + IVₜ₊₃
- NPV10ENTER↓CPTIVₜ = 32.73
CF cash flow worksheet · 2ND second function (the shifted label above a key) · CLR WORK clear the worksheet · ENTER enter (on the HP, puts the number on the stack) · NPV net present value · CPT compute
- 1.82505ENTER1.05×0.1ENTER0.05−÷IVₜ₊₃ = 38.326
- fCLEAR REG
- 0gCF0
- 1.38gCFj
- 1.587gCFj
- 40.1511gCFjDₜ₊₃ + IVₜ₊₃
- 10i
- fNPVIVₜ = 32.73
ENTER enter (on the HP, puts the number on the stack) · f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value
The four classic slips
Each of these changes the answer to the dividend example above, and each appears as an option in exam questions.
| Slip | What it does | Result |
|---|---|---|
| Terminal value from instead of | = 1.8251 ÷ 0.05 = 36.50 | = 31.36 |
| Discount for periods | 38.33 ÷ 1.10⁴ | = 30.11 |
| Grow the first stable year at instead of | = 1.8251 × 1.15 = 2.0988 | = 35.47 |
| Leave undiscounted | 3.937 + 38.326 | = 42.26 |
The correct answer is 32.73. Using in the terminal formula’s denominator breaks it: 15% is above = 10%.
How sensitive is it?
Because the terminal value dominates, small changes to , or move the result a lot. This is the sensitivity to n, g_l and r_e . In the dividend example, with everything else unchanged:
| Long-term growth | |
|---|---|
| 4% | 27.70 |
| 5% | 32.73 |
| 6% | 40.27 |
| Required return | |
|---|---|
| 9% | 41.00 |
| 10% | 32.73 |
| 11% | 27.22 |
For the FCFE example: lengthening the fast stage from four to six years lifts the per-share value from 13.23 to 15.75; raising from 10% to 11% cuts it to 11.52. Analysts therefore test the terminal value, for example by comparing the multiple it implies with the multiples of mature peers.
Which companies need a multistage model?
Use the stages that match how growth will really behave. Constant growth fits a mature company already at a stable rate (lesson 3). Two stages fit a finite spell of above- or below-trend growth followed by a stable rate: a new product, an advantage that fades as rivals arrive, a temporary slump. A different rate for each year fits when the path can be forecast year by year. None of these fits a startup without revenue, or a company being transformed (lesson 7).
Age is not the only test. An old company can find fresh growth, for example by launching a new product line or buying a rival, and that burst is expected to fade back toward a normal rate. Two stages fit. So does a company going through a weak spell that is expected to climb back to its normal growth rate. The test is the shape of the growth path, not the company’s age. Any use of a multistage model must be backed by company and industry analysis (see the industry analysis module).
Exam tip Match the stages to growth you can defend with company and industry analysis. One stable rate: constant growth. A spell, then stability: two stages. Nothing you can defend: use detailed forecasts or multiples.
Go deeper Why the forecast horizon matters
The shorter the fast stage, the larger the share of value left in the terminal value: with 10 growing 8% a year, then 3%, at 9%, the terminal value is 85% of the value over three years, 77% over five and 62% over ten. This is the terminal value share of intrinsic value . Analysts keep the horizon as long as they can forecast with confidence. Lesson 5 picks the long-run growth rate itself.
Go deeper Checking the terminal value
A terminal value is a forecast of what the company will be worth at period . To check it, convert it to a multiple. In the dividend example, of 38.33 against an expected earnings per share can be turned into a price-to-earnings ratio and compared with the ratios of mature companies. If the implied multiple is far above what mature peers trade at, the long-term growth rate or the required return is probably too generous. Learning Module 7 shows how multiples can set or check a terminal value.
Memorize this
MemorizeTwo-stage in four steps
| Step | What to do |
|---|---|
| 1 | Grow CF_t at g_s to get CF_{t+1} … CF_{t+n} |
| 2 | CF_{t+n+1} = CF_{t+n} × (1 + g_l) |
| 3 | IV_{t+n} = CF_{t+n+1} ÷ (r_e − g_l), a value at period n |
| 4 | IV_t = PV of CF_{t+1} … CF_{t+n} + IV_{t+n} ÷ (1 + r_e)^n |
Memory hook The constant growth value sits one period before its first cash flow, so the cash flow you need is the one AFTER the fast stage.
Know it cold Discount IV_{t+n} for n periods, grow the first stable year at g_l, and divide total FCFE values by shares at the end.
MemorizeWhich suits which company
| Company | Model |
|---|---|
| Mature, stable growth below r_e | constant growth |
| A spell of fast or slow growth, then stable | two-stage |
| Path known year by year | a rate for each year |
| Startup without revenue, or transformation | no growth model; detailed forecasts or multiples |
Memory hook One stage per growth regime you can defend.
Know it cold The long-term growth rate must stay below r_e and near the economy's growth.
- Constant growth Use it already stable; mature
- Two-stage Use it a spell of above- or below-trend growth, then stable
- Typical case advantage that fades as rivals arrive
- Also fits a temporary slump before recovery
-
- A rate for each year Know the idea path forecast year by year
- No growth model Know the idea startups without revenue; transformational change
Quick example
D_t = 1.50, growth 12% for two years then 3%, r_e = 10%. D_{t+1} = 1.68, D_{t+2} = 1.8816, IV_{t+2} = 1.938048 ÷ 0.07 = 27.6864. IV_t = 1.68 ÷ 1.10 + (1.8816 + 27.6864) ÷ 1.10² = 25.96.
- CF2NDCLR WORK
- 0ENTER↓1.68ENTER↓↓29.568ENTER
- NPV10ENTER↓CPT 25.9636
CF cash flow worksheet · 2ND second function (the shifted label above a key) · CLR WORK clear the worksheet · ENTER enter (on the HP, puts the number on the stack) · NPV net present value · CPT compute
- fCLEAR REG
- 0gCF01.68gCFj29.568gCFj10i
- fNPV 25.9636
f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value
Quick example
The last fast-stage dividend is 2.50 (year 3), g_l = 5%, r_e = 12%. D_{t+4} = 2.50 × 1.05 = 2.625 and IV_{t+3} = 2.625 ÷ 0.07 = 37.50.
- 2.5×1.05÷(0.12−0.05)= 37.5
- 2.5ENTER1.05× D_{t+4}
- 0.12ENTER0.05− r_e − g_l
- ÷ 37.5
ENTER enter (on the HP, puts the number on the stack)
Quick example
D_t = 1.20, three years at 15%, then 5%. D_{t+4} = 1.20 × 1.15³ × 1.05 = 1.9163.
- 1.2×1.15×1.15×1.15×1.05= 1.9163
- 1.2ENTER1.15×1.15×1.15×1.05× 1.9163
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Two-stage value
D_t 1.50; 12% for 2 years; then 3%; r_e 10%.
IV_{t+2} = 1.938048 ÷ 0.07 = 27.686; IV_t = 25.96. Traps: 25.30 (IV_{t+2} from D_{t+2}), 23.88 (discounted 3 years).
-
Terminal value formula
The terminal value at the end of the fast stage uses which cash flow?
The first cash flow of the stable stage, CF_{t+n+1}. Trap: CF_{t+n}.
-
Which model
Fast growth from a new product, expected to slow to industry growth.
Two-stage model.
-
FCFE per share
FCFE_t 18m; 15% for 4 years; then 3%; r_e 10%; 30m shares.
Equity 396.96m; 13.23 per share. Traps: 18.13 (terminal value not discounted), 12.27 (discounted five years).
Exam traps
- Computing IV_{t+n} from CF_{t+n} instead of CF_{t+n+1}. The constant growth formula needs the next cash flow.
- Discounting IV_{t+n} for n + 1 periods. IV_{t+n} is a value at period n, so discount it n periods.
- Using the fast growth rate g_s in the terminal formula. After period n, growth is g_l.
- Growing the first stable year at g_s instead of g_l.
- Leaving the terminal value undiscounted.
- Using a long-term growth rate at or above r_e, or above the economy's long-run nominal growth.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A company's dividend was USD 2.00 last year. Dividends will grow 10% a year for two years and 4% a year thereafter. The required return on equity is 9%. The share's value is closest to:
2A company's free cash flow to equity for the year just ended was GBP 48 million. An analyst expects it to grow 11% a year for the next three years and 2.5% a year thereafter. The required return on equity is 10.5% and the company has 20 million shares outstanding. The intrinsic value per share is closest to:
3In a two-stage growth model, the terminal value at the end of the fast-growth period is calculated using:
4A company's last dividend of its fast-growth phase, in year 3, is GBP 1.80. After that, dividends grow 3% a year. The required return on equity is 9%. The terminal value at the end of year 3 is closest to:
5A two-stage dividend discount model is most appropriate for a company that:
Key takeaways
- Grow the latest dividend or FCFE at g_s for n periods and discount each.
- IV_{t+n} = CF_{t+n+1} ÷ (r_e − g_l), discounted n periods.
- The terminal value usually dominates, so n, g_l and r_e move the answer most.
- Use two stages for a spell of unusual growth that settles; total FCFE values are divided by shares at the end.
Quick example
D_t = 1.50, growth 12% for two years then 3%, r_e = 10%. D_{t+1} = 1.68, D_{t+2} = 1.8816, IV_{t+2} = 1.938048 ÷ 0.07 = 27.6864. IV_t = 1.68 ÷ 1.10 + (1.8816 + 27.6864) ÷ 1.10² = 25.96.
- CF2NDCLR WORK
- 0ENTER↓1.68ENTER↓↓29.568ENTER
- NPV10ENTER↓CPT 25.9636
CF cash flow worksheet · 2ND second function (the shifted label above a key) · CLR WORK clear the worksheet · ENTER enter (on the HP, puts the number on the stack) · NPV net present value · CPT compute
- fCLEAR REG
- 0gCF01.68gCFj29.568gCFj10i
- fNPV 25.9636
f gold shift key · CLEAR REG clear all registers · g blue shift key · CF0 cash flow at time zero · CFj cash flow j · i interest rate per period · NPV net present value
Quick example
The last fast-stage dividend is 2.50 (year 3), g_l = 5%, r_e = 12%. D_{t+4} = 2.50 × 1.05 = 2.625 and IV_{t+3} = 2.625 ÷ 0.07 = 37.50.
- 2.5×1.05÷(0.12−0.05)= 37.5
- 2.5ENTER1.05× D_{t+4}
- 0.12ENTER0.05− r_e − g_l
- ÷ 37.5
ENTER enter (on the HP, puts the number on the stack)
Quick example
D_t = 1.20, three years at 15%, then 5%. D_{t+4} = 1.20 × 1.15³ × 1.05 = 1.9163.
- 1.2×1.15×1.15×1.15×1.05= 1.9163
- 1.2ENTER1.15×1.15×1.15×1.05× 1.9163
ENTER enter (on the HP, puts the number on the stack)
All Equities formulas, every lesson
Practice exam-style questions on Discounted Cash Flow and Growth Models
Questions about this lesson?
Where this comes back
- Discount rates and terminal values Discounted Cash Flow and Growth Models
- Relative Valuation with Multiples Equities
Questions candidates ask
How do you calculate a two-stage growth model?
Discount each fast-growth cash flow. Compute the constant growth value at the end of the fast stage from the next period's cash flow, discount it back n periods and add the two parts. Divide by shares if the cash flows are totals.
When do you use a multistage model?
When growth is expected to change, typically a spell of unusually high or low growth before a stable rate.
Why is the terminal value so large?
It captures every cash flow from the end of the forecast horizon to infinity, which is most of a growth company's worth.
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