1. Terminal Value Methods
So now that we have calculated WACC, we can discuss the two methods
used to estimate terminal value. Remember, most DCF models have a discrete
forecast stage and a terminal value stage. The first terminal value estimate
we discuss is usually known as the perpetuity growth method.
Basically, we take the last forecasted unlevered free cash flow,
and we grow it for one year at some perpetual growth rate.
The perpetual growth rate is usually based off the long term
nominal GDP growth rate of a mature market economy,
usually around 2% to 4%. Basically, we assume that all future growth in
the terminal value comes solely from economic growth.
Once we calculate that perpetual cash flow, we divide that perpetual cash
flow by WACC minus G. This captures all of the value after our
discreet forecast stage. Again, remember that we still have to discount
this terminal value back to the present value.
The second method for estimating a terminal value is by applying a valuation
multiple, which we will discuss in more detail later in this course.
Basically, we assume the target company will be acquired at the end of
our discreet forecast at some multiple. Since we are performing an unlevered
DCF, we want to use an enterprise value multiple,
the most common of which is enterprise value to EBITDA.
To calculate the terminal value under this method, we simply multiply our
last forecasted EBITDA by the enterprise value to EBITDA multiple.
This is known as either the terminal multiple approach or the exit multiple
approach. Just like under the perpetuity growth method, you'll need to discount
this terminal value back to the present value.
One thing to note, while we might discount cash flows as if they
occur in the middle of the year versus the end of the year,
we always assume the terminal multiple approach happens at the end of the
year. Lastly, the terminal value makes up the bulk of a company's value.
So we want to be very careful when selecting perpetual growth rates and
exit multiples. Now, let's look at an example
and then calculate the terminal values in our model.
2. Let's practice!