Terminal value plays a crucial role in forecasting the value of a business by considering its projected cash flows at the end of the forecast period. It is an essential component of the Discounted Cash Flow (DCF) valuation method, as it helps determine the present value of anticipated future cash flows. When calculating the terminal …
Terminal value plays a crucial role in forecasting the value of a business by considering its projected cash flows at the end of the forecast period. It is an essential component of the Discounted Cash Flow (DCF) valuation method, as it helps determine the present value of anticipated future cash flows. When calculating the terminal value, one considers the expected growth rates and discounts them back to their current Present Value (PV). This means that terminal value captures all cash flows beyond what you can reasonably project.
For instance, if you are forecasting five-year cash flows, your terminal value would represent the sixth-year onward cash flows. Another way of looking at terminal value is to consider it as the company’s market value if it were to be sold in the exit year. We believe that this perspective is usually the missing link between a DCF valuation and a multiples valuation. In most valuation financial models, you expect to find a DCF that is higher than your multiples valuation. We believe that a key reason for this is the calculation of terminal values that do not have a good correlation with market expectations at the point of exit.
As a general rule, your terminal value should account for 50% – 70% of your valuation. Of course, the number could go as high as 90% for some startups. Startups usually have more value in the terminal value as they are not yet generating cashflows that can be valued, with most of this expected to be realized in the future. The longer your projection period, the less significant your terminal value becomes because it represents a lower portion of your total discounted cashflows and vice versa. It is important to obtain a realistic estimation of the terminal value as it is crucial for ensuring the reasonableness of your overall valuation.
Damodaran’s book ‘Investment Valuation’ talks of three approaches for estimating terminal value: Liquidation Value, Multiples Approach, and Stable Growth Approach. In this blog, we will delve into the Multiples approach to understand why Terminal Value matters.
Of the three approaches, we favor the multiples approach. Multiples, by their nature, are usually sourced from comparable transactions or publicly traded companies. In our view, this means they are closer to market expectations than going for other approaches. We believe as a valuer of a company, one should spend time asking themselves whether their implied multiple on exit is one that the company could reasonably be sold for. Below we illustrate how that can be done.
Assuming we were valuing Safaricom, we could assume that it has a WACC of 15% and a terminal growth rate of 5%. Using this information, we can then find Safaricom’s implied multiple using the below formula:
The next step involves evaluating Safaricom’s implied multiple compared to other listed telcos worldwide. This comparative analysis allows you to determine the suitability of the chosen multiple for valuation purposes. For example, suppose most telcos are trading at an EBITDA (Earnings Before Interest Tax Depreciation and Amortization) multiple of 6x. In that case, valuing Safaricom may pose a challenge, as the resulting value will deviate significantly from the expectations.
To get the terminal value, we will apply the EBITDA multiple to Safaricom’s EBITDA. It is important to note that the multiple applied often varies depending on whether we are valuing the firm’s revenues, EBITDA, Book Value etc.
Terminal value plays a significant role in assessing a company’s total valuation. It holds substantial importance as it typically contributes between 50% – 70% to the total valuation. As such, when valuing a company, careful consideration should be given to the selection of the multiple, discount rate, and growth rate applied, as these factors greatly influence the final company valuation.
When valuing private companies, it is important to use a realistic multiple as it significantly influences the final valuation. Relying solely on the discounted cash flow (DCF) method may not provide the desired level of accuracy. Therefore, conducting reality checks, such as obtaining the implied multiple on exit, becomes crucial in ensuring a more realistic valuation.
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