Introduction to Terminal Value DCF
Mr. Bosch got inspired by Robin’s returns from share market investment and invested in some appealing stocks without thinking too much. Down the time, some stocks performed well but some stocks fell like anything. Mr. Bosch, who was very enthusiastic in the beginning, lost his entire money. Due to this incident, he made a firm decision that he will never invest money in the stock market.
So what went wrong with Mr. Bosch’s investment strategy?
It’s a good thing that he took inspiration from Robin, but before investing in the stocks he could have done some research on the company in which he wanted to invest his precious money.
Let’s see, what kind of research would have been beneficial in his case.
Hopeful investors are always, curious about knowing the future cash flow of the company. But as we know publicly-traded organization has an infinite lifetime. Hence it is not possible for us to estimate the cash flows forever. Therefore for a particular growth period, we can estimate the cash flows. And for making long term cash flow growth we use a terminal value approach, which is based on some assumptions.
Terminal Value DCF (Discounted Cash Flow) Approach
Terminal value is defined as the value of an investment at the end of a specific time period, including a specified rate of interest. With terminal value calculation, companies can forecast future cash flows much more easily.
When calculating terminal value it is important that the formula is based on the assumption that the cash flow of the last projected year will stabilize and it will continue at the same rate forever.
There are different ways to find out the terminal value of cash flows. Most popularly used is the Gordon Growth Model where a company is valued as Perpetuity.
Gordon Growth Model
This model assumes that the company will continue its historic business and it generates FCF’s at a steady state.
In this method, Terminal Value is calculated as:
=Final Projected Free Cash Flow*(1+g)/(WACC-g)
g=Perpetuity growth rate (at which FCFs are expected to grow)
WACC= Weighted Average Cost of Capital (Discount Rate)
This formula is purely based on the assumption that the cash flow of the last projected year will be steady and continue at the same rate forever.
Perpetuity growth rate is the rate that is between the historical inflation rate and the historical GDP growth rate. Thus the growth rate is between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%. Hence if the growth rate assumed in excess of 5%, it indicates that you are expecting the company’s growth to outperform the economy’s growth forever.
For “XYZ Co.” we have forecasted Free Cash Flow of $22 million for year 5 and the Discount Rate calculated is 11%. If we assume that the company’s cash flows will grow by 3% per year.
We can calculate the Terminal Value as:
XYZ Co. Terminal Value = $22Million X 1.03/ (11% – 3%)
Following are the general steps to be followed in valuation:
Step 1: Free Cash Flow Calculation
First, we need to calculate Free Cash Flow to the Firm. This is a very crucial step for finding out terminal value as based on the fifth year’s Cash flow we will calculate Terminal Value.
In this we require the following information:
- Net Income of the firm
- Depreciation and Amortization expenses
- Stock-based compensation
- Interest after Tax
- Capital Expenditure
- Intangibles investment
- Changes in Working Capital
Following is the formula used for calculating Free Cash Flow to the Firm:
Step 2: Calculate WACC (Weighted Average Cost of Capital) Terminal value DCF
Now in the second step, we have to calculate the cost incurred on working capital.
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D (Total Capital Value)
E/V = Equity Proportion to the total capital
D/V = Debt Proportion to the total capital
Tc = corporate tax rate
From the above formula, we can see that we need to calculate the cost of equity and cost of debt.
We will calculate Cost of equity by using the CAPM formula.
CAPM= Rf + Beta (Rm – Rf)
Next we will calculate WACC as Cost of debt is assumed in our case.
Step 3: Estimate the Terminal Value Terminal value DCF
Now as discussed above, we can apply the formula and calculate the terminal value.
Here we have to link FCFF value starting from the forecasted year. Hence it is called an explicit forecast.
Step 4: Discount FCFF
In the following step, we are calculating the Present value of an explicit forecast period by using the Excel function XNPV.
XNPV(rate, values, dates)
rate= discount rate to be applied on cash flows.
values= a series of cash flows
dates= schedule of payment date.
Step 6: Find the Enterprise Value.
In this step, we will calculate the Total Enterprise value by summation of the Present value of explicit forecast period and Present Value of Terminal Value.
Step 7: Adjust Enterprise Value to arrive at Equity Value
In this step, we have to find out the intrinsic value of the firms which is calculated as:
Step 8: Find the fair price of Google share
Now we can easily find the fair price of Google’s share by simply dividing the intrinsic value by total no. of shares.
Thus by applying the same technique, we can find out the share price of any organization. If the calculated share price comes out to be more than the current market price, in that case, the recommendation will be to BUY that share and the company is said to be undervalued. In other cases if the calculated fair price of the share is less than the current market price then the recommendation will be to SELL that share and the company is said to be overvalued.
Let’s look at the other method of finding out Terminal Valu
Terminal Multiple Method
This is another way of determining the terminal value of cash flows. It assumes that the company will be valued at the end of the projection period, based on public market valuations. It is calculated by using a multiplier of some income or cash flow measures such as EBITDA (Earnings Before Interest Depreciation Amortization), EBIT (Earnings Before Interest Tax).
Multiple should reflect the ongoing growth potential of the business. It should be based on the appropriate multiple used in that particular industry (EBITDA/EBIT/EBITDA)
E.g. 10x EBITDA
There are some variations of multiple users in the terminal multiple approaches:
- P/E Multiple: P/E multiple is calculated as Market Price Per-share divided by Earnings Per Share which indicates investors willing to pay for the company’s earnings.
- Market to Book multiple: This compares stock’s market price to its book value. Market to Book multiple is an indication of how much shareholders are paying for the net assets of a company.
- Price to Revenue multiple: It indicates the value of the company’s stock price to its revenue. It’s an indicator of the value placed on each dollar of the company’s revenue or sales.
Here we need to know:
- Multiple is derived from the valuation of comparable companies.
- Normalized multiples should be used.
- Multiple should reflect the long term market valuation of the company rather than a current multiple that may be distorted by industry or economic cycle.
- And it is very important to do Sensitivity analysis on multiples
In the above example EBITDA expected for the year 2013 is $113 Million and EBITDA transaction multiple is 7x,
Terminal Value= EBITDA (2013)* Multiple
Using Multiples in valuation has certain advantages like Ease of use as it is based on market values and it provides a useful stage for estimation. But the disadvantage lies in finding comparable values in the industry as the firms may differ from each other to a greater extent.
We would like to suggest to Mr. Bosch, that:
The accuracy of DCF valuation is dependent upon the quality of the assumptions, with the factors FCF, TV and discount rate. The inputs in valuation are from variety of resources, they must be viewed factually.
Terminal Value represents a high percentage of the DCF valuation. In future there can be fluctuations in real time values which may cause increase or decrease in actual terminal value. So the Risk is the factor which should be taken care of.
Terminal value DCF Infographics
Learn the juice of this article in just a single minute, Terminal value DCF infographics.
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