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Home Terminal Value in Discounted Cash Flows: A Primer

Terminal Value in Discounted Cash Flows: A


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

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Download

Why we calculate Terminal Value


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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The confidence level of financial statement projection diminishes exponentially


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

Why Terminal Value is important for Discounted Cash Flows


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

Terminal Value Concept


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

Terminal Value Calculations


There are two approaches for calculating the Terminal Value of the Firm. Download the
Terminal Value Excel Sheet for the example below -

1) Perpetuity Growth Method


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.

Using cool maths, we can simplify the formula as per below -

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.

2) Exit Multiple Method


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.

Terminal Value Calculation Example in Excel


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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Number of shares = 100


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

Share Price Calculation using Perpetuity Growth Method for Terminal


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

Step 3 - Calculate the Present Value of the Terminal Value

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Step 4 - Calculate the Enterprise Value and the Share Price

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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Step 3 Calculate the Present Value of the Terminal Value

Step 4 - Calculate the Enterprise Value and the Share Price

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.

Alibabas Terminal Value (using Perpetuity Growth Method)


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 3. Calculate the Net Present Value of the Terminal Value.

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

Can Terminal Value be Negative?


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!

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