You will be able to calculate a terminal value two ways and check whether it is reasonable.
Marcus spent an evening on Larkspur's five-year forecast, adjusting growth, margins and working capital until each year felt right. Then he added the terminal value and found that his five careful years made up about a quarter of the total. The other three quarters came from one formula that stood for every year after FY10. That's normal, and it's why the terminal value deserves as much care as the forecast itself.
Figures are made up and in S$ millions unless stated.
A business doesn't stop at year five. The terminal value is the value, at the end of the forecast, of all the cash flows after it. It's calculated once and then discounted back to today like any other cash flow.
For Larkspur at a 9% discount rate, the five forecast years of free cash flow to the firm, about 32.4, 35.4, 38.3, 41.0 and 43.5, have a present value of about 146.5. The terminal value, by the growth method below, is about 634 at the end of FY10, worth about 412 today. Enterprise value is about 558.6, and the terminal value makes up about 74% of it.
For faster-growing companies, whose cash flows are small now and large later, the share is often higher still. So the terminal value isn't a detail you add at the end. It's the largest single assumption in the model.
The growth method assumes that after the forecast, free cash flow grows at a constant rate for ever. The value at the end of year five is next year's cash flow divided by the discount rate minus the growth rate.
For Larkspur, FY10 free cash flow of about 43.5, grown by 2% for FY11, is about 44.4. Divided by 9% minus 2%, which is 7%, that gives about 634.
The growth rate has to be modest. A company can't grow faster than the economy around it for ever, or it would eventually become the economy. Analysts usually set long-term growth at or below long-run nominal economic growth, and often near expected long-run inflation. Marcus used 2%. It must also stay well below the discount rate. As the two converge, the denominator shrinks towards zero and the value heads towards infinity, and a value like that tells you an input is broken.
The growth rate and reinvestment are linked. A company growing at 2% for ever needs to keep reinvesting enough to support that growth. If your final forecast year has capital spending far below depreciation, the terminal value assumes growth without the investment to pay for it. Check that year five looks like a business in a steady state.
The other approach assumes the business is sold at the end of the forecast at a multiple of its earnings, usually enterprise value to EBITDA, taken from what similar companies trade at today.
Larkspur's FY10 EBITDA in the model is about 100.4: operating profit of about 69.5 plus depreciation of about 30.9. At a made-up exit multiple of 7 times, the terminal value is about 703, worth about 457 today. Enterprise value becomes about 603.4, and the terminal value's share rises to about 76%. Value per share is about S$1.94, against about S$1.80 by the growth method.
The exit multiple is simple and connects the value to real prices. That's also its weakness. It brings today's market pricing back into a method meant to value the business independently of the market. If peers are expensive now, the multiple makes your DCF expensive too.
The best use of the two methods is to test each with the other.
From the growth method, work out the multiple it implies: the terminal value divided by final-year EBITDA. Larkspur's 634 divided by 100.4 is about 6.3 times EBITDA. Is that a reasonable price for a mature precision engineer? Look at what similar companies trade at, which module 9 sets up in lesson 9.3, Choose a peer group that is really comparable. If your growth method implies 15 times EBITDA for a cyclical parts maker, your growth rate or margins are too high.
From the exit multiple, work out the growth rate it implies. Rearranging the growth formula, the implied growth rate is the terminal value times the discount rate minus the final cash flow, all divided by the terminal value plus the final cash flow. For Larkspur at 7 times EBITDA, that's about 2.6% a year for ever. Is that believable for a supplier to a cyclical industry, in a world where long-run inflation might be around 2%? It's on the high side. A multiple that implies growth of 5% for ever is a multiple you can't defend.
When the two methods disagree by a wide margin, one of them is wrong, and the cross-check tells you which assumption to question. Marcus's methods gave S$1.80 and S$1.94. The gap was small enough to live with, and the implied growth of 2.6% made him prefer the growth method's more cautious answer as his base case.
For the activity, calculate your company's terminal value by both methods, then work out what share of total enterprise value each one makes up.
Calculate your company's terminal value by both methods and write down what share of total value each makes up.
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