CFA Level II ExamEquity InvestmentsMedium
An equity analyst is performing a valuation of 'GreenHarvest Inc.', a rapidly growing organic food producer. The analyst expects GreenHarvest's Free Cash Flow to Equity (FCFE) to grow at a high rate of 15% for the next two years, then at a moderate rate of 8% for the subsequent three years, and finally stabilize at a perpetual growth rate of 3% thereafter. The required rate of return for equity is 12%. This valuation approach, characterized by distinct growth phases, is known as a:
- AOne-Stage Free Cash Flow to Equity Model
- BThree-Stage Free Cash Flow to Equity Model
- CTwo-Stage Free Cash Flow to Equity Model
- DGordon Growth Model
Show answer & explanationAnswer & explanation
Correct answer: B. Three-Stage Free Cash Flow to Equity Model
The scenario describes three distinct growth phases for FCFE: a high-growth phase (15% for 2 years), a moderate-growth phase (8% for 3 years), and a stable, perpetual growth phase (3% thereafter). This structure precisely fits the definition of a Three-Stage Free Cash Flow to Equity Model, which is used for companies with varying growth patterns over time.
Why the other options are wrong
- A. A one-stage model assumes a constant growth rate from the beginning, which is not the case here.
- C. A two-stage model assumes only two phases: an initial high growth phase followed by a stable growth phase, missing the intermediate moderate growth phase described.
- D. The Gordon Growth Model is a one-stage model, assuming only a constant perpetual growth rate, which is only part of this scenario.
Three-Stage FCFE Model
A Free Cash Flow to Equity (FCFE) valuation model that incorporates three distinct phases of growth: an initial high-growth period, followed by a transition/moderate-growth period, and then a stable, perpetual growth period.
- Used for companies with complex growth profiles.
- Allows for more realistic modeling of growth deceleration.
- Requires careful estimation of growth rates for each stage.
Memory trick: FCFE Stages: One, Two, Three for Growth.