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However, in practice using the first-year prospective metric is generally good enough. To be precise, a forward 12-month prospective earnings should be used (usually a combination of first and second year prospective earnings). The earnings metric should be forecast not historical. Make sure this reflects differences in risk and leverage. This is the normal economic cost of equity capital in other words, it is the required return of equity investors in respect of their investment in the entity. Unfortunately, the relationship between accounting and economic returns is a complex one (and perhaps a subject for a future article). As a result, the returns used in the model would generally be high for a company where it is primarily intangible investment that drives value. The difference between accounting and economic returns is often due to the limited recognition of intangible investment in financial reporting most investment in intangible assets is immediately expensed rather than capitalised and amortised. The reason is that the model uses this return to determine the difference between reported earnings and the cash flow that ultimately determines value. The additional investment used in the calculation of incremental returns should be what is capitalised in the financial statements. Incremental returns used in the model are accounting returns, which may not necessarily be the same as economic returns.
Trminal growth rate of stock driver#
Incremental return on capital determines cash conversion and is a key value driver However, historical returns may be relevant when estimating forecast incremental returns as efficient use of capital previously invested and a high historical return may well indicate that future incremental returns will also be high.
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Historical investment by equity investors is a sunk cost and does not directly impact value. The historical return on equity calculation of earnings divided by shareholders’ equity is backward looking as regards the investment and should not be used. It represents the forecast increase in profit in a given period divided by the increase in equity capital. The return input is a forward-looking incremental return expected to be earned on incremental investment. It is an impossible scenario anyway because, theoretically, such a rate produces an infinite valuation and the entity would eventually end up bigger than the economy. The model will not accept a rate greater than the cost of equity. Remember that this rate is applied in perpetuity. If the initial phase is long and growth is high and volatile then using an average rate could be a problem and a more sophisticated multi-period approach would be necessary.įor long-term growth, it is important to consider what rate is a sustainable, considering the market and economy as a whole. However, in most cases, using an average expected rate will not have a significant effect on the target multiple.
![trminal growth rate of stock trminal growth rate of stock](https://www.educba.com/dcf-discounted-cash-flow/wp-content/uploads/2014/03/step2-wacc.jpg)
For the initial phase it may be simplistic to assume that growth is constant when actual growth forecasts differ for each period. This is the expected rate of growth in earnings.
Trminal growth rate of stock drivers#
Interactive model: Price earnings ratio implied by value drivers