Terminal Value for DCF method of Valuation

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Permalink Reply by Chandra Shekar on July 10, 2008 at 8:20am

You have to take terminal value by considering the growht rate till n th year.
for more explanation just browse damodarn online study material.

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Permalink Reply by Dipu James on July 10, 2008 at 8:34am

if you could explain with 1 small example?

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Permalink Reply by Chandra Shekar on July 10, 2008 at 8:52am

Closure in Valuation
Since you cannot estimate cash flows forever, you generally impose closure in
discounted cash flow valuation by stopping your estimation of cash flows sometime in
the future and then computing a terminal value that reflects the value of the firm at that
point.
Value of a Firm =
CFt
(1 + kc )t +
t=1
t=nå Terminal Value n
(1 + kc )n
You can find the terminal value in one of three ways. One is to assume a liquidation of
the firm’s assets in the terminal year and estimate what others would pay for the assets
that the firm has accumulated at that point. The other two approaches value the firm as a
going concern at the time of the terminal value estimation. One applies a multiple to
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earnings, revenues or book value to estimate the value in the terminal year. The other
assumes that the cash flows of the firm will grow at a constant rate forever – a stable
growth rate. With stable growth, the terminal value can be estimated using a perpetual
growth model.
Liquidation Value
In some valuations, we can assume that the firm will cease operations at a point in
time in the future and sell the assets it has accumulated to the highest bidders. The
estimate that emerges is called a liquidation value. There are two ways in which the
liquidation value can be estimated. One is to base it on the book value of the assets,
adjusted for any inflation during the period. Thus, if the book value of assets ten years
from now is expected to be $2 billion, the average age of the assets at that point is 5 years
and the expected inflation rate is 3%, the expected liquidation value can be estimated.
Expected Liquidation value = Book Value of AssetsTerm yr (1+ inflation rate)Average life of
assets
= $ 2 billion (1.03)5 = $2.319 billion
The limitation of this approach is that it is based upon accounting book value and does
not reflect the earning power of the assets.
The alternative approach is to estimate the value based upon the earning power of
the assets. To make this estimate, we would first have to estimate the expected cash
flows from the assets and then discount these cash flows back to the present, using an
appropriate discount rate. In the example above, for instance, if we assumed that the
assets in question could be expected to generate $400 million in after-tax cash flows for 15
years (after the terminal year) and the cost of capital was 10%, your estimate of the
expected liquidation value would be:
Expected Liquidation value = ( ) ( ) $3.042 billion
0.10
1.10
1
1-
$400 million
15
=
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When valuing equity, there is one additional step that needs to be taken. The
estimated value of debt outstanding in the terminal year has to be subtracted from the
liquidation value to arrive at the liquidation proceeds for equity investors.
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Multiple Approach
In this approach, the value of a firm in a future year is estimated by applying a
multiple to the firm’s earnings or revenues in that year. For instance, a firm with expected
revenues of $6 billion ten years from now will have an estimated terminal value in that
year of $12 billion if a value to sales multiple of 2 is used. If valuing equity, we use equity
multiples such as price earnings ratios to arrive at the terminal value.
While this approach has the virtue of simplicity, the multiple has a huge effect on
the final value and where it is obtained can be critical. If, as is common, the multiple is
estimated by looking at how comparable firms in the business today are priced by the
market. The valuation becomes a relative valuation rather than a discounted cash flow
valuation. If the multiple is estimated using fundamentals, it converges on the stable
growth model that will be described in the next section.
All in all, using multiples to estimate terminal value, when those multiples are
estimated from comparable firms, results in a dangerous mix of relative and discounted
cash flow valuation. While there are advantages to relative valuation, and we will consider
these in a later chapter, a discounted cash flow valuation should provide you with an
estimate of intrinsic value, not relative value. Consequently, the only consistent way of
estimating terminal value in a discounted cash flow model is to use either a liquidation
value or a stable growth model.
Stable Growth Model
In the liquidation value approach, we are assuming that your firm has a finite life and
that it will be liquidated at the end of that life. Firms, however, can reinvest some of their
cash flows back into new assets and extend their lives. If we assume that cash flows,
beyond the terminal year, will grow at a constant rate forever, the terminal value can be
estimated as.
Terminal Valuet =
stable
t 1
r - g
Cash Flow +
where the cash flow and the discount rate used will depend upon whether you are valuing
the firm or valuing the equity. If we are valuing the equity, the terminal value of equity
can be written as:
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Terminal value of Equityn =
n 1 n
n 1
Cost of Equity - g
Cashflow to Equity
+
+
The cashflow to equity can be defined strictly as dividends (in the dividend discount
model) or as free cashflow to equity. If valuing a firm, the terminal value can be written
as:
Terminal valuen =
n 1 n
n 1
Cost of Capital - g
Cashflow to Firm
+
+
where the cost of capital and the growth rate in the model are sustainable forever.
In this section, we will begin by considering how high a stable growth rate can be,
how to best estimate when your firm will be a stable growth firm and what inputs need to
be adjusted as a firm approaches stable growth.
Constraints on Stable Growth
Of all the inputs into a discounted cash flow valuation model, none can affect the
value more than the stable growth rate. Part of the reason for it is that small changes in the
stable growth rate can change the terminal value significantly and the effect gets larger as
the growth rate approaches the discount rate used in the estimation. Not surprisingly,
analysts often use it to alter the valuation to reflect their biases.
The fact that a stable growth rate is constant forever, however, puts strong
constraints on how high it can be. Since no firm can grow forever at a rate higher than the
growth rate of the economy in which it operates, the constant growth rate cannot be
greater than the overall growth rate of the economy. In making a judgment on what the
limits on stable growth rate are, we have to consider the following questions.
1. Is the company constrained to operate as a domestic company or does it operate
(or have the capacity) to operate multi-nationally? If a firm is a purely domestic
company, either because of internal constraints (such as those imposed by
management) or external (such as those imposed by a government), the growth
rate in the domestic economy will be the limiting value. If the company is a multinational
or has aspirations to be one, the growth rate in the global economy (or at
least those parts of the globe that the firm operates in) will be the limiting value.
Note that the difference will be small for a U.S. firm, since the U.S economy still
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represents a large portion of the world economy. It may, however, mean that you
could use a stable growth rate that is slightly higher (say 1/2 to 1%) for a Coca
Cola than a Consolidated Edison

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Permalink Reply by Dipu James on July 10, 2008 at 9:02am

good this will help it seems thank you very much.

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Permalink Reply by Dipu James on July 18, 2008 at 2:32am

damodaran on terminal value

Attachments:

• damodaran on terminal value.pdf, 71 KB

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Permalink Reply by Daniel Chow on July 18, 2008 at 4:02am

Fantastic stuff Dipu - thanks for sharing.

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Permalink Reply by Rambo on March 2, 2009 at 10:15am

can anyone tell me how to come up with a terminal value if the growth rate is higher than the discount rate? thx

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Permalink Reply by Toby O'Brien on March 2, 2009 at 8:29pm

You have encountered a strange academic problem for "cash flow perpetuity calculations".

The Cash flow Perpetuity method for calculating terminal value, being broadly CF/(d-g) should only be applied when "g" is predicted to be constant from the terminal year onwards (in perpetuity). Without knowing your numbers, I would suggest that if "g" is higher than your discount rate that either:
(a) your discount rate is too low; or
(b) your high growth rate is unlikely to remain constant forever.

In order to tease out the discussion to resolve the issue, I would recommend that you extend your financial model out for more years (perhaps even extend it to 30-40 years), which will:
(i) make your terminal value a less material component of your total valuation; and
(ii) require a time series of growth rate assumptions (rather than one growth rate number) over a longer period of time.

Hope this helps.

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Permalink Reply by Dipu James on March 3, 2009 at 3:20am

thanks toby

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Permalink Reply by Parjeet Singh on March 4, 2010 at 1:43am

What is the impact of changes in terminal value on the overrall valuation?

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Permalink Reply by SITI FAZLINA BINTI MUSTAFA on March 26, 2010 at 3:23am

good morning..my name issiti from malaysia i'm not understand about DCF.what do you think the key variable allowed for in a DCf investment appraisal model such as terminal value and what the conclusion from the variable key or set in DCF?can you explain for me...

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Permalink Reply by SITI FAZLINA BINTI MUSTAFA on March 26, 2010 at 3:31am

my question...

how the following key variable are determine allowed for in a DCF investment appraisal model.
a.holding period for analysis
b.rental growth
c.depreciation
d.outgoing
e.exit yield
f.terminal value..

I hope somebdy can explain me one by one from the list

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