Forecasting Future Earnings

The first step in DCF analysis is to make a reasonable estimate of the earnings generated by the company for the next 5 to 10 years.

The difficult part of this exercise involve coming up with a realistic growth rate of the company's earnings. We have to apply the appropriate growth model to estimate the company's earnings growth.

Different growth models exist for different companies at various stages of their lifetime. A young company in an emerging industry may experience supernormal growth for the next few years whereas an older larger company in a mature industry may experience little or no growth.

Future earnings growth estimates can also be derived by looking at past earnings growth or by taking the estimates published by the many analysts covering the stock.

Whether we use historical data or analyst estimates, the usual practice is to discount them by about 15% to 20%.

Unless you have a very good idea of how the company will grow, the common approach is to apply the 3-stage growth model whereby we assume that the company will experience the current rate of growth for the next 5 years and then growth tapers off to a slower rate of 5% the following 5 years and finally no growth thereafter.

Chart Showing XYZ's Projected Future Earnings for the Next 20 Years

Using our earlier example, the chart above shows the earnings generated over the next 20 years by XYZ company.

Next: Computing Net Present Value

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