The terminal value in a discounted cash flow (DCF) analysis represents the value of a business beyond the forecast period. Terminal value can be effectively calculated using the two approaches: Perpetual Growth Model and Exit Multiple Method.
Perpetual Growth Model
Calculate the terminal value by applying a perpetual growth rate to the final year’s earnings or cash flows:
Formula:
Terminal Value = Final Year Free Cash Flows * (1 + Perpetual Growth Rate) / (Discount Rate - Perpetual Growth Rate)
Growth Considerations: The perpetual growth rate should typically match the long-term growth rate of the economy, reflecting the expectation that a business will not outpace the overall economic growth indefinitely.
Exit Multiple Method
Another approach involves applying an exit multiple to the earnings or cash flows at the end of the projection period. This multiple can be derived from the trading multiples of similar public companies or pricing multiples of similar M&A transactions.
Normalization of Free Cash Flows
Terminal Value should be based on normalized earnings or free cash flows at the end of the projected period. Normalizing ensures that the cash flows are sustainable and reflective of the company's expected ongoing operations without the influence of any abnormal profit or loss. This prevents skewed valuations based on unusually high or low earnings.
Normalization of earnings: Ensure that earnings in the final year are normalized for revenue growth and margins, acknowledging that excessively high growth or margins are unsustainable due to market conditions and competition.
Normalization of cash flow adjustments: Normalize the final year’s free cash flows considering expected changes in working capital and capital expenditure, ensuring they reflect sustainable future operations.
Special Considerations for High Growth Companies
It is possible for early stage companies or companies in high growth stage to grow at a higher rate than the perpetuity growth post the projection period. In these cases, the following steps can be followed:
Extended Projections: Extend the projection period if the business is likely to grow significantly beyond the initial forecast period.
Two-Stage H-Model: Use a two-stage model where an initial high growth phase transitions to a stable growth phase, at which point the business matures and grows at a perpetual rate.
Importance of Sensitivity Analysis
Given that terminal value often constitutes a major portion of the total enterprise value in DCF models, perform a sensitivity analysis to assess the impact of changes in key inputs like growth rates and discount rates on the DCF results. This helps validate the reliability of the analysis.