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TerminalValue|PerpetuityGrowth&ExitMultipleMethod
Terminal value is the value of a companys expected free cash flow beyond the period of
explicit projected financial model.This tutorial focuses on ways in which Terminal Value is
calculated in the context of Company Financial Model.
Why we calculate Terminal Value?
Why Terminal Value is important for Discounted Cash Flows
Terminal Value Concept
Terminal Value Calculations Perpetuity Growth & Exit Multiple Method
Terminal Value Excel Example
Alibabas Terminal Value (using Perpetuity Growth Method)
Can Terminal Value ever be Negative?
Useful Downloads 1) Free Terminal Value Excel Templates (used in the post) and2) Alibaba
IPO Terminal Value Calculation Model
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It is advisable that you also read through other brokerage house research
reports to understand how they have modeled sales numbers.
Forecast the financial statements for the next 5 years (explicit forecast period)
financial model
When you forecast the companys financial statements, you must only project
the financial statements of the company for the next 4-5 years and generally not
beyond that.
We can theoretically project the financial statements for the next 100-200
years, however, if we do so, we introduce lot of volatility based on
assumptions.
Step #3: Find the fair Share Price of the Firm by discounting the FCFF and Terminal Value
Calculate FCFF for the next 5 years as derived from the Financial Model
Apply a suitable WACC (weighted average cost of capital) from the capital
structure calculations.
Calculate the Present value of the Explicit Period FCFF
Calculate the Terminal Value of the Company (period beyond the Explicit
Period)
Enterprise Value = Present alue (Explicit Period FCFF) + Present Value (Terminal
Value)
Find Equity Value of the Firm after deducting Net Debt
Divide Equity Value of the Firm by the total number of shares to arrive at
Intrinsic Fair Value of the company.
Recommend whether to BUY or SELL
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t = time, WACC is weighted average cost of capital or discount rate, FCFF is the Free Cash
Flows to Firm
We can break the above formula into two parts 1) Present Value of Explicit forecast 2)
Present Value of Terminal Value
Numerator of the above formula can also be written as FCFF (6) = FCFF (5) x (1+
growth rate)
The revised formula is as follows -
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A reasonable estimate of the stable growth rate here is the GDP growth rate of the
country.
In addition to the above information, you have the following information Debt = $100
Cash = $50
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Step 2 - Calculate the Terminal Value of the Stock (at the end of 2018) using
Perpetuity Growth method
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Please note that in this example, Terminal Value contribution towards Enterprise value
is 78%! This is no exception. Generally you will note that the Terminal Value
contribution is between 60-80% of the total value.
Share Price Calculation using Exit Multiple Method for Terminal Value
Step 1 - Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast
period (2014-2018). Please refer to the above method, where we have already
completed this step.
Step 2 - Calculate the Terminal Value of the Stock (at the end of 2018) using Exit
Multiple Method. Let us assume that in this industry, the average companies are
trading at 7x EV/EBITDA multiple. We can apply this very same multiple to find the
terminal value of this stock.
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Please note that in this example, Terminal Value contribution towards Enterprise
value is 77%!
With both the methods, we are getting share prices that are very close to each other.
Sometimes, you may note large variations in the share prices and in that case, you
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need to validate your assumptions to investigate such large difference in share prices
using the two methodologies.
Step 1 Calculate the NPV of the Free Cash flow to Firm of Alibaba for the explicit period
(2015-2022)
Step 2 Calculate the Terminal value of Alibaba at the end of year 2022 In this DCF
model, we have used the Perpetuity Growth method to calculate the Terminal Value of
Alibaba
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Step 4 Calculate the Enterprise Value and Fair Share Price of Alibaba
Please note that Terminal Value contributes approximately 72% of the total Enterprise
Value in case of Alibaba
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growth method
In the formula above, if we assumeWACC < growth rate, then the Terminal Value derived
from the formula will be Negative. This is very difficult to digest as a high growth company
is now showing a negative terminal value just because of the formula used. However, this
high growth rate assumption is incorrect. We cannot assume that a company is going to
grow at a very high rate until infinite. If this is the case, then this company will attract all
the capital available in the world. Eventually, the company would become the entire
economy and all people working for this company (Awesome, unfortunately this is
unlikely!)
When doing valuation, a negative terminal value doesnt exist practically. However, if the
company is in huge losses and is going to bankrupt in the future, the equity value will
become zero. Another case could be if companys product is becoming obsolete like the
typewriters or pagers or Blackberry(?). Here also, you may land up in a situation where
equity value may literally become closer to zero.
Conclusion
Terminal Value is a very important concept in Discounted Cash Flows as it accounts for
more than 60%-80% of the total valuation of the firm. You should put special attention in
assuming the growth rates (g), discount rates (WACC) and the multiples (EV/EBITDA or
EV/EBIT). It is also helpful to calculate the terminal value using the two methods
(perpetuity growth method and exit multiple method) and validate the assumptions used.
Whats Next?
If you learned something new or enjoyed the post, please leave a comment below.Let me
know what you think. Many thanks and take care. Happy Learning!
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