12.3 Terminal Value Calculation

Terminal value calculation is a crucial step in DCF valuation, estimating a company's worth beyond the forecast period. Two main methods are used: the perpetuity growth method and the exit multiple method.

Each approach has its strengths and challenges. The perpetuity growth method assumes constant growth, while the exit multiple method uses industry comparisons. Understanding these methods is key to accurate company valuations.

Perpetuity Growth Method

Calculating Terminal Value with Constant Growth

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• Terminal value represents the value of a company's expected cash flows beyond the explicit forecast period in a discounted cash flow (DCF) valuation
• The perpetuity growth method, also known as the Gordon Growth Model, assumes that a company's cash flows will grow at a constant rate forever after the explicit forecast period
• To calculate the terminal value using this method, divide the cash flow in the first year after the explicit forecast period by the discount rate minus the long-term growth rate
  • Formula: $\text{Terminal Value} = \frac{\text{Cash Flow}_{t+1}}{\text{Discount Rate} - \text{Long-term Growth Rate}}$
  • Cash flow in the first year after the explicit forecast period is typically estimated by growing the final year's cash flow by the long-term growth rate

Estimating Long-term Growth Rate

• The long-term growth rate is a critical assumption in the perpetuity growth method and should reflect the expected growth of the company's cash flows in perpetuity
• A common approach is to use the long-term expected growth rate of the economy or industry in which the company operates (GDP growth rate)
• For mature companies in developed markets, a long-term growth rate of 2-3% is often used, reflecting the expected long-term inflation rate
• High-growth companies may warrant higher long-term growth rates, but should eventually converge to the economy's growth rate as they mature

Exit Multiple Method

Calculating Terminal Value with Exit Multiple

• The exit multiple method estimates a company's terminal value by applying a valuation multiple to a financial metric (EBITDA, EBIT, or revenue) in the final year of the explicit forecast period
• Common multiples used in this method include Enterprise Value (EV) to EBITDA, EV to EBIT, and Price to Earnings (P/E)
• To calculate the terminal value using the exit multiple method, multiply the chosen financial metric in the final year of the explicit forecast period by the appropriate multiple
  • Formula: $\text{Terminal Value} = \text{Financial Metric}_t \times \text{Valuation Multiple}$
  • Example: If a company's EBITDA in the final year of the forecast period is $100 million and the chosen EV/EBITDA multiple is 8x, the terminal value would be$800 million

Selecting an Appropriate Multiple

• The choice of multiple depends on the company's industry, growth prospects, and profitability
• EV/EBITDA is a commonly used multiple as it is unaffected by differences in capital structure and tax rates between companies
• Multiples should be based on comparable companies or transactions in the same industry
• Forward-looking multiples based on expected future financial metrics are preferred over historical multiples
• It is important to ensure consistency between the financial metric used in the multiple and the cash flows being discounted in the DCF valuation