Discount model part 1: Basics
In the next four articles I will discuss the discount model and the various variances: the cashflow discount model, the dividend discount model and the profit discount model. In this article, the idea behind the discount model, the one and two stage discount model, and the calculation of the discount models are explained. In the following articles I will discuss each of the three variances.
Discount model purpose
The discount model is what it says it is: with it you can calculate the present value of the future earnings of a company or share. This means that the future earnings, whether it are the cashflow, dividends or profits, can be discounted. With the discount model, you can value a company or share using the probable future earnings. The discount model is used by investors all over the world to value companies, find cheap companies and invest in those.
Not every investor will have the same outcome from the different discount model. This depends partly on the choice of discount model (cashflow, dividend or profit) and on the assumptions and predictions an investor has. So, before you can use a discount model, you should have done some research about the cashflow, dividends or profits and their expected growth.
One and two stage discount model
Besides the variances of the discount model, there are also two types of discount models: the one stage and the two stage discount model. The difference between the one stage and two stage discount model are important, because the calculation differs between the discount models.
The one stage discount model only takes into account the long term growth of a company. When using the one stage discount model, you assume that the company will grow (the growth of the cashflow, dividends or profits) forever with the same rate.
But most companies do not grow forever with a fixed rate. This is where the two stage discount model enters. The first stage of this two stage discount model is the calculation of the companies growth in the first number of future years. The second stage equals the one stage discount model. So, when using the two stage discount model, you can differ your calculation for the earnings of the coming few years and the earnings in the years further in the future.
You can for example assume that the cashflow of a company will grow faster in the first ten years, and that in the years beyond the first ten years the rate of the growth will decrease. With the two stage discount model, you can first discount the earnings in the ten coming years, taking into your calculation a rapid rate of growth. In the second stage, you can use a smaller growth rate of the earnings. This will make the outcome of the discounted earnings more realistic.
Discount model calculation
Now that you know the purpose and the difference between the one and two stage discount model, you obviously would like to know the exact calculation of the discount model. First of all, the calculation of the first stage of the two stage discount model. You will need to know a few variables. You will have to determine the growth rate of the earnings (by calculating the growth rate of the past few years or in any other way you would like to determine this growth rate). Second of all, you will need to guess the interest rate (or discount rate) for the coming years (or just take the current rate). The last variables are the current earnings and the number of years for the first stage. The calculation of the first stage of the two stage discount model:
discounted earnings year 1 = current earnings x growth rate1 x (1/interest rate)1
discounted earnings year 2 = current earnings x growth rate2 x (1/interest rate)2
discounted earnings year 3 = current earnings x growth rate3 x (1/interest rate)3
discounted earnings year ..
etcetera (until the desired number of years for stage 1)
The calculation of the second stage of the two stage discount model (or the first stage of the one stage discount model) is slightly different. You will need the same variables, but the growth rate should be different. The growth rate should be below the interest rate (or discount rate), because otherwise the outcome will be infinite and thus not calculable. The earnings of the last year of the first stage will be used as starting earnings. The calculation of the second stage of the two stage discount model or the total calculation of the one stage discount model:
discounted earnings after stage 1 = starting earnings * interest rate
value earnings stage 2 = discounted earnings after stage 1 / (interest rate - growth rate)
discounted earnings stage 2 = value earnings stage 2 * growth ratelast year stage 1
A calculation never speaks for itself. Therefore I have made a tool in which you can calculate the net present value of future earnings of companies (currently only Dutch companies). You can see the calculation in action and the outcome of the calculation is explained in this calculation tool.
Next time: discounted cashflow model
In the next article, I will discuss the discounted cashflow model.