DCF Analysis - Calculating the Terminal Value

Question 1

What is the difference between the explicit forecast period and the Terminal Period in a DCF?

Answer 1

The company’s Free Cash Flow growth rate, and possibly its Discount Rate, change over time in the explicit forecast period since you forecast cash flow in each year.

But in the terminal period, you assume the company remains in a “steady state”: Its Free Cash Flow grows at the same rate each year, and its Discount Rate remains the same.

Question 2

What’s the intuition behind the Gordon Growth formal for Terminal Value?

Answer 2

The intuition is that a company is worth less if the Discount Rate is higher and worth more if the Terminal FCF Growth Rate is higher.

That’s because the company is worth more when you have worse investment options elsewhere, and worth less when you have better investment options elsewhere.

Question 3

How do you pick the Terminal Growth Rate when you calculate the Terminal Value using the Gordon Growth Method?

Answer 3

This growth rate should be below the country’s long term GDP growth rate and in-line with other macroeconomic variables like the rate of inflation.

Question 4

What’s one problem with using EV / EBITDA multiples to calculate Terminal Value?

Answer 4

The biggest issue is that EV / EBITDA ignores CapEx. So two companies with similar EV / EBITDA multiples might have very different Free Cash Flow and FCF growth figures. As a result, their Implied Values might differ significantly even if one multiple is similar for both of them.

Question 5

Would it ever make sense to use a negative Terminal FCF Growth Rate?

Answer 5

Yes, a negative Terminal FCF Growth Rate represents your expectation that the company will stop generating cash flow eventually.