3rd Step: Terminal Value Calculation:
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What is Terminal Value and How to calculate?
When you preform DCF valuation, you forecast cash flows only for an explicit forecast period but DCF valuation is based on the principle that the company is a going concern and it will operate perpetually and generate cash flows even after explicit forecast period, but we can’t forecast the cash flows perpetually with any degree of accuracy.
So we make a simplified assumption and calculate the value of company at the end of forecast period and that value is called terminal value.
Terminal Value represents the value of all those cash flows which would be generated after forecast period.
Terminal Value is calculated with two methods.
- Perpetual Method: In this method, we assume that after the forecast period the company will generate cash flows growing at a constant rate. Growth rate is generally the long term growth rate of industry.
Terminal Value = Terminal FCFF*(1+Growth Rate)
(WACC – Growth rate)
The perpetuity growth method is not used as frequently in practice due to the difficulty in estimating the perpetuity growth rate and determining when the company achieves steady-state. However, the perpetuity growth rate implied using the terminal multiple method should always be calculated to check the validity of the terminal multiple assumption.
- Terminal Multiple Method
The terminal multiple method inherently assumes that the business will be valued at the end of the projection period, based on public markets valuations. The terminal value is typically calculated by applying an appropriate multiple (EV/EBITDA, EV/EBIT, EV/ Revenue, EV / Cash Flows or other equity multiples etc.) to the relevant statistic projected for the last projected year.
If you take the assumption of EBITDA Multiple then
Terminal Value = Terminal EBITDA * Assumed EBITDA Multiple
In FCFF model, we assume Enterprise value multiples
In FCFF Model, we assume Equity Value multiples
The exit multiple assumption is usually developed based on selected companies’ trading multiples or precedent transaction multiples. Assuming the terminal multiple is being applied to the statistic projected for the last projection year, be sure to use a trailing multiple rather than a forward multiple.
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