Key Rule 4

Question 1

Key rule 4:
- calculating terminal value, 2 methods:

Answer 1

1. Assume that the company gets sold for a certain multiple
2. Assume that the company keeps operating indefinitely and sum its future cash flows.

Question 2

Method 1 - assume company sold for a certain multiple - known as multiples method

Answer 2

If company has EBITDA of 500 million in year 5, based on public comps, might be worth 10x EBITDA, so approximate value is £5 billion.
- downside is exact multiple hard to estimate years in advance, so use a range of multiples in the analysis and show results in a sensitivity table with different discount rates too.

Question 3

Method 2 - assume that the company keeps operating indefinitely and sum its future cash flows

Answer 3

Assumption that growth is forever.
- present value of FCF each year shrinks once discount rate is higher than the growth rate
- so cumulative sum converges to a single number.

Question 4

Terminal Value formula

Answer 4

Terminal Value = Final Year Free Cash Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate – Terminal FCF Growth Rate).

Terminal growth rate must be correct, low, less than or equal to countries GDP growth rate usually, otherwise, company’s FCF will exceed GDP of whole country.

Question 5

Derivation for terminal value formula

Answer 5

Geometric series, so sum = a/(1-r)
Use Gordon growth formula to find a and r
a = present value of FCF one year into model
- final year FCF x (1 + growth rate)/ (1+ discount rate)
r = common ratio
- (1 + growth rate)/ (1 + discount rate)
Equate TV to a/1-r above, end up with:
Final year FCF x (1+ growth rate)/ (discount rate - growth rate)

Question 6

Which method to use?

Answer 6

Almost always use both and compare the results.
- main disadvantage is that key variable - terminal multiple and terminal growth rate are difficult to determine precisely.
- if industry is cyclical or multiplies are hard to predict GGM may be better
- if multiples are easier to estimate, MM may be better.

Question 7

Once you have TV

Answer 7

Discount it using the same discount rate, then add it to the discounted value of the company’s FCFs
- this gets you enterprise value if UFCF, or EV with LFCF
- then you can work out company’simplied share price