3.9) DCF Analysis - Calculating the Terminal Value Flashcards
- What is the difference between the explicit forecast period and the Terminal Period in a DCF?
The company’s Free Cash Flow Growth Rate, and possibly its Discount Rate, change over time in the explicit forecast period since the company is still growing and changing.
But in the Terminal Period, you assume that the company remains in a “steady state” forever: Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.
- What’s the intuition behind the Gordon Growth formula for Terminal Value?
The typical formula is:
Terminal Value = Final Year FCF * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal FCF Growth Rate)
But it’s more intuitive to think of it as:
Terminal Value = FCF in Year 1 of Terminal Period / (Discount Rate – Terminal FCF Growth Rate)
A company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher.
For example, let’s say the company’s FCF is not growing, and its Discount Rate is 10%. It earns $100 in FCF in the first year of the Terminal Period.
You would be willing to pay $100 / 10%, or $1,000, so the Terminal Value is $1,000. If the Discount Rate falls to 5%, now you’d pay $100 / 5%, or $2,000. If it increases to 20%, you’d pay $100 / 20%, or $500.
The company is worth more when you have worse investment options elsewhere and worth less when you have better investment options elsewhere. Now let’s say the company’s FCF is growing. If it grows by 3% per year, you’d be willing to pay $100 / (10% – 3%), or ~$1,429 for it. But if its FCF growth rate increases to 5% per year, you’d be willing to pay $100 / (10% – 5%), or $2,000, for it.
Higher growth lets you achieve the same targeted returns even when you pay more.
- If you use the Multiples Method to calculate Terminal Value, do you use the multiples from the Public Comps or Precedent Transactions?
It’s better to start with the multiples from the Public Comps, ideally the ones from 1-2 years into the future, because you don’t want to reflect the control premium in the Precedent Transactions if you’re completing a standalone valuation of the company.
If the selected multiples imply a reasonable Terminal FCF Growth Rate, you might stick with your initial guess; if not, adjust it up or down as necessary.
- How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?
This growth rate should be below the country’s long-term GDP growth rate and in-line with other macroeconomic variables like inflation.
For example, if you’re in a developed country where the expected long-term GDP growth rate is 3.0%, you might use numbers ranging from 1.0% to 2.0% for the range of Terminal Growth Rates.
You should NOT pick a rate above the country’s long-term GDP growth rate because the company will become bigger than the economy as a whole if you go far enough into the future.
You can then check your work by calculating the Terminal Multiples implied by these growth rates.
- Why do you need to discount the Terminal Value back to its Present Value?
Because the Terminal Value represents the Present Value of the company’s cash flows from the end of the explicit forecast period into perpetuity. In other words, it represents the company’s value AT a point in the future. Valuation tells you what a company is worth TODAY, so any “future value” must be discounted to its Present Value. If you did not discount the Terminal Value, you’d greatly overstate the company’s Implied Value because you’d be acting as if its Year 6, 11, or 16 cash flows arrived in Year 2 instead.
- When you discount the Terminal Value, why do you use the number of the last year in the forecast period for the discount period (for example, 10 for a 10-year forecast)? Shouldn’t you use 11 since Terminal Value represents the Present Value of cash flows starting in Year 11?
No. The Terminal Value does represent the Present Value of cash flows starting in Year 11, but it’s the Present Value as of the end of Year 10.
You would use 11 for the discount period only if your explicit forecast period went to Year 11 and the Terminal Period started in Year 12.
- What do you do after summing the PV of Terminal Value and the PV of Free Cash Flows?
If you’re building a Levered DCF analysis, you’re almost done because this summation gives you the company’s Implied Equity Value. The last step is to divide the company’s Implied Equity Value by its diluted share count to get its Implied Share Price (if the company is public). In an Unlevered DCF, the PV of Terminal Value + PV of Free Cash Flows equals the company’s Implied Enterprise Value, so you have to “back into” the Implied Equity Value and then calculate its Implied Share Price. You do this by adding non-operating Assets (Cash, Investments, etc.) and subtracting Liability and Equity items that represent other investor groups (Debt, Preferred Stock, Noncontrolling Interests, etc.). Then, you divide by the company’s diluted share count to get its Implied Share Price.
- The diluted share count includes dilution from the company’s in-the-money options. But what about its out-of-the-money options? Shouldn’t you account for them in a DCF?
In theory, yes. Some academic sources use Black-Scholes to value these out-of-the-money options and then subtract them to determine the company’s Implied Equity Value. In practice, banks rarely include out-of-the-money options in a DCF. These options tend to make a small impact on most companies, and options valuation is tricky and requires inputs that you may or may not have. So, it is usually not worth the time and effort.
- How can you check whether or not your Terminal Value estimate is reasonable?
It’s an iterative process: you start by entering a range of assumptions for the Terminal Multiple or Terminal FCF Growth Rate, and then you cross-check your assumptions by calculating the Growth Rates or Multiples they imply. If it seems wrong, you adjust the range of Terminal Multiples or Terminal FCF Growth Rates until you get more reasonable results.
Example: You start by picking 10x TEV / EBITDA for the Terminal Multiple. At a Discount Rate of 12%, this multiple implies a Terminal FCF Growth Rate of 5%, which is too high. So, you reduce it to 6x TEV / EBITDA, but now the Implied Terminal FCF Growth Rate drops to 1%, which is too low. So, you guess 8x TEV / EBITDA, which implies a Terminal FCF Growth Rate of 2.3%. That is more reasonable since it’s below the expected long-term GDP growth rate but slightly above the inflation rate. This 8x figure might be your “Baseline Terminal Multiple,” so you would start there and go slightly above and below it in the sensitivity tables.
- What’s one problem with using TEV / EBITDA multiples to calculate Terminal Value?
The biggest issue is that EBITDA ignores CapEx. Two companies with similar TEV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if they have similar TEV / EBITDA multiples. You may get better results by using TEV / EBIT, TEV / NOPAT, or TEV / Unlevered FCF, but those multiples create other issues, such as less comparability across peer companies. This problem is one reason why the Gordon Growth Method is still the “real” way to calculate Terminal Value.
- Would it ever make sense to use a negative Terminal FCF Growth Rate?
Yes. For example, if you’re valuing a biotech or pharmaceutical company and the patent on its key drug expires within the explicit forecast period, it might be reasonable to assume that the company never replaces the lost revenue from this drug, which results in declining cash flow. A negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually (even if it happens decades into the future). It doesn’t make the company “worthless”; the company is just worth less.
- How can you determine which assumptions to analyze in sensitivity tables for a DCF?
The same assumptions make a big impact in any DCF: the Discount Rate, the Terminal FCF Growth Rate or Terminal Multiple, and the key operational drivers that affect the company’s revenue growth and margins. These drivers could be entire scenarios or specific numbers, such as the long-term price of steel, depending on the model setup. It doesn’t make sense to sensitize much else – the assumptions for CapEx and the Change in Working Capital, for example, tend to make a small difference. There may also be industry-specific assumptions that are worth sensitizing, such as the patent expiration dates for drugs in the biotech/pharmaceutical industry.
