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Lesson 6 of 9 · 15 min
Growth assumptions for any cash flow: constant, implied and two-stage
The constant and two-stage growth models work for FCFE and FCFF as well as dividends; the market price can be turned into an implied growth rate, and growth itself is estimated from history (watch the base year) or from the sustainable growth rate.
In short
- General constant growth model: , with r matched to the cash flow. It suits mature, stable firms.
- An FCFE value of total cash flows is the equity value: divide by shares; do not subtract debt.
- g must be below r and, long term, should not exceed nominal economic growth. Firms in decline can have negative g.
- Implied growth: : the steady growth the price assumes.
- Historical growth rates suffer from the base effect: a spike or trough in the starting year biases the rate.
- SGR = (1 − payout) × ROE; with FCFE use 1 − FCFE/NI; with FCFF use (1 − FCFF/NOPAT) × return on capital.
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