DCF Terminal Value

9 Key excerpts on "DCF Terminal Value"

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  Financial Valuation

  Applications and Models

  • James R. Hitchner(Author)
  • 2017(Publication Date)
  • Wiley

    (Publisher)

  The terminal value is the value of the business after the explicit or forecast period. 146 FINANCIAL VALUATION EXHIBIT 5.16 Formula for Multistage Models PV= i n 1 = ∑ 1 NCF g k i i 0 1 1 1 + ( ) + ( ) + i n n = + ∑ 1 2 1 NCF g k NCF g k g k n i i n n 2 1 2 1 1 1 1 2 3 3 + ( ) + ( ) + + ( ) - ( ) + ( ) Where: k = The cost of capital PV = Present value i = A measure of time (in this example the unit of measure is a year) n 1 = The number of years in the first stage of growth n 2 = The number of years in the second stage of growth NCF 0 = Cash flow in year 0 NCF n 1 = Cash flow in year n 1 NCF n 2 = Cash flow in year n 2 g 1 = Growth rate from year 1 to year n 1 g 2 = Growth rate from year (n 1 + 1) to year n 2 g 3 = Growth rate starting in year (n 2 + 1) ValTip The terminal value is critical, as it often represents a substantial por- tion of the total value of an entity, particularly when using a three- to five-year interim period. The example in Exhibit 5.17 shows that the present value of the terminal value could actually be greater than the sum of the interim cash flows (explicit period) as well as the total value of the common equity. This is not an uncommon occurrence. Calculation of the Terminal Value In a DCF, the terminal value is the value of the company at the beginning of year n + 1. This value often is calculated by using the Gordon Growth Model (GGM), which is the same math that is used in the capitalization of cash flow method. It is as shown in Exhibit 5.18. Because making accurate forecasts of expected cash flows after the explicit peri- od is difficult, the analyst usually assumes that cash flows (or proxies for cash flows) stabilize and can be capitalized into perpetuity. This is an average of future growth rates, not one expected to occur every year into perpetuity. In some years growth will be higher or lower, but the expectation is that future growth will average the long- term growth assumption.

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  Performance Dashboards and Analysis for Value Creation

  • Jack Alexander(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  For Simple Co.:

  Assuming future growth after 2014 at g percent:

  For Simple Co.:

  Since an argument can be made supporting both methods, I recommend computing a range of estimated terminal values using both multiples and economic value. Understanding the underlying reasons for the different values is informative and should be explored. One of the estimates must ultimately be selected and used for the terminal value. Since the estimate of TV is usually significant to the overall valuation, a sensitivity analysis using multiple estimates of the terminal value should be created. This analysis should provide a more comprehensive understanding of the impact of key assumptions on the valuation of the company.

  Common mistakes in estimating the terminal value include using inappropriate price-earnings (P/E) multiples or unrealistic post-horizon growth rates. The P/E multiple used in the TV estimate should be consistent with the performance estimated for the post-horizon growth period. This may be significantly different than current P/E ratios reflecting current performance. Post-horizon growth rates should be modest, since perpetuity means forever! Few companies achieve high levels of growth over extended periods, and most companies’ growth rates decline to overall economic growth levels or even experience declines in sales over time.

  Step 4: Discount the Cash Flows

  The DCF valuation method can be utilized to estimate the total value of the firm or the value of equity. Typically, we estimate the total value of the firm by projecting total cash flows available to all investors, both equity and debt. We then discount the cash flows at the weighted average cost of capital (WACC), which is an estimate of the returns expected by investors. Discount rates and the cost of capital are explored in greater detail in Chapter 10.

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  Equity Valuation

  Models from Leading Investment Banks

  • Jan Viebig, Thorsten Poddig, Armin Varmaz, Jan Viebig, Armin Varmaz, Thorsten Poddig, Jan Viebig, Armin Varmaz, Thorsten Poddig(Authors)
  • 2008(Publication Date)
  • Wiley

    (Publisher)

  DCF valuation is a useful exercise to understand what an investment is worth in equilibrium. Like every model, DCF models are based on simplifying assumptions. Trading on the basis of fundamental values can be painful if the no-arbitrage argument or the going-concern assumption does not hold. In summary: (1) Virtually every sophisticated equity valuation model used by leading investment banks today is a discounted cash flow (DCF) model. The fundamental value of an investment derived by DCF models is the present value of its expected, future cash flows. (2) Investors compare assets and have preferences for high returns, low risk and liquidity. The expected return which is foregone by investing in a specific asset rather than in a comparable investment is called opportunity cost of capital. The fundamental value of an asset depends on its opportunity cost of capital. (3) While the present value rule applies both to bonds and equities, several important differences exist: Cash flows to equity holders are more uncertain; equity holders do not receive a redemption value at maturity; the opportunity costs of equity cannot readily be observed in the markets and therefore must be modeled; interest rate sensitivity measured by duration is the key value driver of bonds, the value drivers of equities are more plentiful. (4) When applying DCF models, investors have to estimate the expected cash flows during the competitive advantage period, the terminal value and the opportunity cost of capital. The opportunity cost of capital consists of the risk-free rate plus a risk premium, which adequately reflects the uncertainty of future cash flows. Cash flows and opportunity costs should be consistent. (5) Fundamental values are calculated assuming that a company will employ its operating assets to generate cash flows, will continue its operation and will not liquidate its assets.

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  Financial Modeling and Valuation

  A Practical Guide to Investment Banking and Private Equity

  • Paul Pignataro(Author)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  This only gives us the value of the company over the first few projected years. What about the value of the company after the last projected year? In other words, if we have built a five-year model, discount-ing the UFCFs gives us the implied value of the company for just the first five years. The terminal value of a company estimates the value of the business after the last estimated year. There are two major methods for calculating the terminal value of a company: ▪ ▪ Multiple method ▪ ▪ Perpetuity method Multiple Method The multiple method applies a multiple to the final projected year’s finan-cials. Typically, an EBITDA multiple is applied to the company’s final-year EBITDA. The value of the company in year 2025, for example, is the value we can sell the company for in 2025. So if we are using a 5 × EBITDA mul-tiple, and if the company’s 2025 EBITDA is 100,000, then we believe we can sell the company for 500,000. The multiple to use can come from compara-ble companies, or we can take the company’s current market EBITDA mul-tiple. Taking the company’s current market multiple can be considered a conservative approach (unless the company is extremely overvalued). Discounted Cash Flow Analysis 309 In other words, if we sell the company in five years for at least what it is worth today (on a multiple basis), and we assume EBITDA is growing, then the total sale value should be higher. Once we have the terminal value, we then discount that value back to PV. Perpetuity Method The perpetuity method is based on a typical perpetuity, which is a steady stream of cash flows with no end. The formula for a perpetuity termi-nal value is: UFCF ( ) 1 g r g where r is the discount rate (the WACC) and g should represent the perpet-ual rate of cash flow growth.

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  Capital Investment & Financing

  a practical guide to financial evaluation

  • Chris f Agar(Author)
  • 2005(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  All of these inputs (1)-(3) are expressed in real terms (i.e. the currency value at date t). (See Madden (1998) for further discussion.) Implications for Terminal Values The final year n Free Cash Flows, on which the TV largely depends, should be based on (1) rates of return that are economically justifiable (competitive forces should drive down rates of return towards sustainable levels, possibly at or just above the WACC) and (2) margins and reinvestment rates that reflect the company’s relatively mature stage. Whilst the n year forecast can be extended until such a ‘steady state’ arises, it is possible to use a ‘two-stage’ formula (valuing cash flows over an interim terminal period, during which cash flows converge to a steady state, and valuing cash flows in perpetuity thereafter). Terminal Value Formulae Although there are other methods of estimating the TV (such as using P/E, EBITDA or cash flow multiples, or the break-up or liquidation value), the following discussion focuses on valuing cash flows in perpetuity. Year n is the final forecast year (usually year 10), and n+1 is the first terminal year. In the examples given, year n is year 5 from Example B1.18 . Year n + 1 Free Cash Flows to the Firm (FCF) in perpetuity 1. Year n FCF with no growth FCF n+1 = FCF n (This assumes a decrease in FCF in real terms if a nominal WACC is used – Arzac (2005 p.82)). TV = FCF n+1 WACC 2. Year n FCF with constant growth FCF n+1 = FCF n x g* TV = FCF n+1 . WACC – g Enterprise Value - Terminal Value 197 B1.29 The growth rate, g*, may or may not be the same as the perpetuity growth rate ‘g’ – the adjustment g* is simply an adjustment to FCF n to set up the sustainable cash flow. The marginal return (ROIC m ) will remain constant, although the Invested Capital will increase at a decreasing rate, reducing the average return (ROICav), eventually down to ROIC m .

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  Corporate Financial Reporting and Analysis

  A Global Perspective

  • S. David Young, Jacob Cohen, Daniel A. Bens(Authors)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  This approach is sum- marized in the formula: Value CF t t n t t r 1 1 where n is the economic life of the investment (usually expressed in years) 2 ; CF t is the expected cash flow in period t; and r is the discount rate that reflects the perceived riskiness, or uncertainty, of the cash flows. This equation tells us that the value of any asset, including a business enterprise, is equal to the sum of DCF. The discount rate is the opportunity cost of capital, which measures the return that investors would expect to receive if the cash were invested elsewhere in assets or companies of similar risk. 3 Business Valuation and Financial Statement Analysis 155 Valuation: From Theory to Practice Valuation: From Theory to Practice The value of the firm equals the present value of its future cash flows, or more specifically, “free cash flows,” plus the value of any existing cash balances. We define free cash flow as the amount of cash generated in any given year from the company’s operations, net of the investment to be made in that year. Recalling the cash flow statement, all cash flows are the result of operating, investing, or financing activities. Think of free cash flow as operating cash flows, net of investing cash flows, thus representing the amount of operating cash left over for distribution to the firm’s capital providers. It’s the prospect of receiving such cash in future that motivates investors to contribute cash now. Free cash flow is calculated as follows: Operating income Depreciation Investment Free Cash Fl ( ) 1 T ow Operating income, sometimes known as EBIT, or Earnings before Interest and Tax, is the profit expected from the firm’s normal, recurring business activities (sales – operating expenses). When operating income is multiplied by (1 – T ), where T is the corporate tax rate, the result is net operating profit after tax, or NOPAT. Depreciation (amortization too, if there is any) is added back because it is not a cash expense.

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  Corporate and Project Finance Modeling

  Theory and Practice

  • Edward Bodmer(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Chapter 25 . If the company is not sold and cash flows are always realized in the middle of the year, the value of the company should be the same as if you separately compute the present value of explicit period cash flows and the present value of terminal cash flow. This long-term theoretical exercise demonstrates that all of the business of midyear discounting ends up in a simple formula that can be implemented as follows:

  • Compute the value of explicit cash flows and the value of the terminal value as if you were using the end-of-year cash flows, meaning that you can use the regular old NPV function.
  • Multiply the final result by (1 + WACC)^.5 to adjust for the half-year assumption.

  To demonstrate that this formula works, you can create a proof in the same manner for proving how items associated with the bridge between enterprise value and equity value should be treated. The value of cash flows in the long-term model establishes the theoretically correct value of the company. This is the same value that should be obtained from the sum of the terminal value and the value of the explicit cash flow. The value of the terminal cash flow as measured by the terminal value is in a sense just a shortcut, as the buyer at the terminal date should pay the theoretical long-term value. When you assume that the explicit cash flows occur at the middle of the period and the terminal value occurs at the end of the period, but the buyer makes a valuation from receipt of cash flow in the middle of the period, the valuation is the same as the simple formula shown earlier. Figure 28.4

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  Negotiating successfully

  Negotiating successfully in small and mid-sized M&A transactions

  • Arnd Allert, Holger Knoblauch(Authors)
  • 2015(Publication Date)
  • Kuebler

    (Publisher)

  In any case, methods for determining multiples can only be a supplementary element in the valuation of enterprises. Any company transaction that is meant to be sincere, rational and aimed at creating value has to include a detailed analysis of the earnings and the liquidity in the form of a discounted cashflow analysis and valuation.

  However, since this analytical instrument is relatively complex in its arithmetical application and presentation, depending on the other party it can be advisable to transform the results of this discounted cashflow method into a multiple, which is easier to use in negotiation practice.

  A good presentation of a DCF valuation always also shows the implied multiples following from the result as well as – by means of sensitivity calculations – the effects on the key indicators in the event of changing parameters.

  Figure 78Sample DCF analysis with implied multiples and sensitivity analyses

  The upper part shows the calculation of the enterprise value resulting from the DCF method. The middle part shows implied multiples. At the bottom of the table, the results are described by means of so-called sensitivity analyses (on the left for the enterprise value and on the right for the EV/EBITDA multiple) which will occur upon variation of the costs of capital and the perpetuity growth rate.

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  Discounted Cash Flow

  A Theory of the Valuation of Firms

  • Lutz Kruschwitz, Andreas Loeffler(Authors)
  • 2006(Publication Date)
  • Wiley

    (Publisher)

  A not too strong growth of the expected business value in the future suffices: lim t→ E V t 1 + k t = 0 in which k is the firm’s cost of capital. Since the case of an infinite lifespan corresponds more to fiction than a true-to-life condition, we are convinced that this is a ‘technical assumption’. If it is not accepted, the danger exists of getting entangled in serious contradictions. 3 With regard to practical use, our condition would not be problematical. In the formally orientated 2 If cost of capital in the amount of 10 % and constant cash flows are implied, then the first 30 years explain virtually 95 % of the firm’s total value. 3 If, for example, a firm that is being looked at finds enough valuable investments over an infinite period, no free cash flows are generated in this case. Since the firm’s free cash flow is always at zero, the firm’s value (if the transversality condition is not taken into consideration) will also be zero – although the firm is certainly worth more than nothing. 8 Basic Elements literature, so-called ‘transversality’ is spoken of when the discounted business value is heading towards zero with the advance of time. Trade and payment dates It is necessary to specify the trade and payment dates of our model. An investor, who owns a share, gets the cash flow at just the right time before t (see Figure 1.2). If she sells this security at t, then the buyer always pays a ‘price ex cash flow’. Although this arrangement is fully normal within the framework of the DCF approach, we explicitly stress it here. It leads to not being able to illustrate particular trading strategies in our model. For dividend stripping, for instance, a share would have to be bought immediately before the dividend payment – a comportment our model does not allow. Continuous or discrete time We have decided that the firm to be valued will be observed over a timeframe of several periods.

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