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Terminal Value: perpetuity Growth and exit multiple method

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TerminalValue|PerpetuityGrowth&ExitMultipleMethod

Primer

July 31, 2014 by Dheeraj Vaidya 23 Comments

Terminal value is the value of a companys expected free cash flow beyond the period of

explicit projected financial model.This tutorial focuses on ways in which Terminal Value is

calculated in the context of Company Financial Model.

Why we calculate Terminal Value?

Why Terminal Value is important for Discounted Cash Flows

Terminal Value Concept

Terminal Value Calculations Perpetuity Growth & Exit Multiple Method

Terminal Value Excel Example

Alibabas Terminal Value (using Perpetuity Growth Method)

Can Terminal Value ever be Negative?

Useful Downloads 1) Free Terminal Value Excel Templates (used in the post) and2) Alibaba

IPO Terminal Value Calculation Model

YourEmail

Download

Terminal value calculation is a key requirement of the Discounted Cash Flow.

It is very difficult to project the companys financial statements showing how

they would develop over a longer period of time.

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for years which are way farther from today.

Also, macro economic conditions affecting the business and the country may

change structurally

Therefore, we simplify and use certain average assumptions to find the value of

the firm beyond the forecast period (called as Terminal Value) as provided by

Financial Modeling.

Following graph shows how to calculate Terminal Value

In this section, i have briefed the overall approach to performing the Discounted Cash

Flows or DCF valuation of any company. Especially, please note Step # 3where we

calculate Terminal Value of the Firm to find the Fair value of Share.

Step # 1: Create the Infrastructure(not discussed in this article)

Prepare a blank excel sheet with Separate Income Statement, Balance Sheet and Cash

Flows (last 5 years)

Populate the historical financial statements (IS, BS, CF) and do the necessary adjustment

for Non-recurring items (one time expenses or gains).

Perform the Ratio Analysis for Historical years to understand the company

Step #2: Project the Financial Statements and FCFF(not discussed in this article)

Forecasting of Income Statement (P&L) is most important for analysts. Hence,

you must devote lot of time to this. In this, you need to read through the annual

report and other documents to get a solid understanding of forecasting

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It is advisable that you also read through other brokerage house research

reports to understand how they have modeled sales numbers.

Forecast the financial statements for the next 5 years (explicit forecast period)

financial model

When you forecast the companys financial statements, you must only project

the financial statements of the company for the next 4-5 years and generally not

beyond that.

We can theoretically project the financial statements for the next 100-200

years, however, if we do so, we introduce lot of volatility based on

assumptions.

Step #3: Find the fair Share Price of the Firm by discounting the FCFF and Terminal Value

Calculate FCFF for the next 5 years as derived from the Financial Model

Apply a suitable WACC (weighted average cost of capital) from the capital

structure calculations.

Calculate the Present value of the Explicit Period FCFF

Calculate the Terminal Value of the Company (period beyond the Explicit

Period)

Enterprise Value = Present alue (Explicit Period FCFF) + Present Value (Terminal

Value)

Find Equity Value of the Firm after deducting Net Debt

Divide Equity Value of the Firm by the total number of shares to arrive at

Intrinsic Fair Value of the company.

Recommend whether to BUY or SELL

An important assumption here is theGoing Concernof the company. In other words, the

company will not stop its business operations after a few years, however, it will continue

to do business forever. The value of the firm (Enterprise Value) is basically the present

value of all the future Free Cash Flows to Firm.

We can represent Value of the firm using the formula below -

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t = time, WACC is weighted average cost of capital or discount rate, FCFF is the Free Cash

Flows to Firm

We can break the above formula into two parts 1) Present Value of Explicit forecast 2)

Present Value of Terminal Value

There are two approaches for calculating the Terminal Value of the Firm. Download the

Terminal Value Excel Sheet for the example below -

This method is the preferred method to calculate the Terminal Value of the firm. This

method assumes that growth of the company will continue (stable growth rate) and

the return on capital will be more than cost of capital. We discount the Free cash flow

to firm beyond the projected years and find the Terminal Value.

Numerator of the above formula can also be written as FCFF (6) = FCFF (5) x (1+

growth rate)

The revised formula is as follows -

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A reasonable estimate of the stable growth rate here is the GDP growth rate of the

country.

This approach uses the underlying assumption that market multiple basis is a fair

approachto value a Businesses. A value is typically determined as a multiple

ofEBITorEBITDA. For cyclical businesses,instead ofthe EBITDA orEBITamount at

the end year n, we use an averageEBITor EBITDA over the course of a cycle

For example, if metals and mining sector is trading at 8 times the EV/EBITDA multiple,

then the terminal value of the company implied using this method would be 8 x

EBITDA of the company.

In this example, we calculate the fair value of the stock using the two terminal value

calculation approaches discussed above. You can download theTerminal Value Excel

template for the example below -

In addition to the above information, you have the following information Debt = $100

Cash = $50

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Find the per share fair value of the stock using the two proposed terminal value calculation

method

Value

Step 1 - Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast

period (2014-2018)

Step 2 - Calculate the Terminal Value of the Stock (at the end of 2018) using

Perpetuity Growth method

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Please note that in this example, Terminal Value contribution towards Enterprise value

is 78%! This is no exception. Generally you will note that the Terminal Value

contribution is between 60-80% of the total value.

Share Price Calculation using Exit Multiple Method for Terminal Value

Step 1 - Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast

period (2014-2018). Please refer to the above method, where we have already

completed this step.

Step 2 - Calculate the Terminal Value of the Stock (at the end of 2018) using Exit

Multiple Method. Let us assume that in this industry, the average companies are

trading at 7x EV/EBITDA multiple. We can apply this very same multiple to find the

terminal value of this stock.

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Please note that in this example, Terminal Value contribution towards Enterprise

value is 77%!

With both the methods, we are getting share prices that are very close to each other.

Sometimes, you may note large variations in the share prices and in that case, you

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need to validate your assumptions to investigate such large difference in share prices

using the two methodologies.

You may download Alibabas Financial Model fromhere. Below diagram details the free

cash flow to firm of Alibaba and the approach to find the fair valuation of the firm.

Valuation of Alibaba =Present Value of FCFF (2015-2022) + Present Value of FCFF (2023

until infinite Terminal Value)

Step 1 Calculate the NPV of the Free Cash flow to Firm of Alibaba for the explicit period

(2015-2022)

Step 2 Calculate the Terminal value of Alibaba at the end of year 2022 In this DCF

model, we have used the Perpetuity Growth method to calculate the Terminal Value of

Alibaba

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Step 4 Calculate the Enterprise Value and Fair Share Price of Alibaba

Please note that Terminal Value contributes approximately 72% of the total Enterprise

Value in case of Alibaba

Theoretically YES, Practically NO!

Theoretically, this can happen when Terminal value is calculated using the perpetuity

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growth method

In the formula above, if we assumeWACC < growth rate, then the Terminal Value derived

from the formula will be Negative. This is very difficult to digest as a high growth company

is now showing a negative terminal value just because of the formula used. However, this

high growth rate assumption is incorrect. We cannot assume that a company is going to

grow at a very high rate until infinite. If this is the case, then this company will attract all

the capital available in the world. Eventually, the company would become the entire

economy and all people working for this company (Awesome, unfortunately this is

unlikely!)

When doing valuation, a negative terminal value doesnt exist practically. However, if the

company is in huge losses and is going to bankrupt in the future, the equity value will

become zero. Another case could be if companys product is becoming obsolete like the

typewriters or pagers or Blackberry(?). Here also, you may land up in a situation where

equity value may literally become closer to zero.

Conclusion

Terminal Value is a very important concept in Discounted Cash Flows as it accounts for

more than 60%-80% of the total valuation of the firm. You should put special attention in

assuming the growth rates (g), discount rates (WACC) and the multiples (EV/EBITDA or

EV/EBIT). It is also helpful to calculate the terminal value using the two methods

(perpetuity growth method and exit multiple method) and validate the assumptions used.

Whats Next?

If you learned something new or enjoyed the post, please leave a comment below.Let me

know what you think. Many thanks and take care. Happy Learning!

http://www.wallstreetmojo.com/terminalvaluedcf/

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