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8. The Terminal Value Part 1
The terminal value is a technique used to estimate the discounted cashflows beyond our financial projection period. In this lesson, I show you how to calculate the terminal value using the perpetuity method.
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Lesson Goal (00:00)
The goal of this lesson is to calculate the terminal value for MarkerCo using the perpetuity method.
Understanding Terminal Value (00:04)
The terminal value is used to represent the value of all cashflows beyond a certain point in time, such as the end of a financial projection. It can be calculated using two different methods. This lesson illustrates the perpetuity method.
Using the Perpetuity Method (00:41)
The perpetuity method assumes that the company will grow at a predictable, stable rate into the future. Note that this stable growth rate must be lower than the overall economic growth rate, otherwise the company would eventually become bigger than the economy.
To calculate the terminal value, we take the cashflow for the first year beyond our projection, and divide it by the discount rate minus the stable growth rate. We then discount this value in the same way that we discounted the other future cashflows. When discounting, we assume that the terminal value cashflow is earned in the final year of the financial projections.
Interpreting the Terminal Value (02:45)
In a five-year financial projection, the terminal value usually accounts for about 75% of the value of a business. In a ten-year projection, the terminal value typically represents about 50% of the company’s value. In either case, the terminal value has a significant impact on the valuation of the business.
Issues with the Perpetuity Method (03:24)
The main issue with the perpetuity method is the assumption of a stable growth rate. This assumption is often not realistic in practice. You may prefer to use a different method to calculate terminal value if the stable growth rate assumption is not realistic for the business you are valuing.
In the previous lesson, we performed a discounted cashflow evaluation for Magro Co. However, we only performed a 5 year projection, so the current enterprise value of the business is artificially low. Ow we need to find a way to calculate the value of the remaining cash flows that exist beyond the next 5 years. And to do this, we would use a concept called the terminal value. The terminal value simply represents all the future cash flows beyond a certain point in time. Which I'm going to define as the final year of my projection. The terminal value can be calculated in two ways. The first of which is the perpetuity method. This method assumes that company will continue to grow at a stable rate into the future. The formula for the terminal value, using the perpetuity method is the cashflow in year 6 divided by the discount rate minus the growth rate. So let's start by assuming a stable growth rate of say, 1.5%.
It's important to keep this growth rate under the average GDP growth rate, otherwise Magro Co. would eventually become bigger than the economy itself. Next, let's calculate the cash flows in year 6 of our projections. And to do this, it's very simple. We go to our unlevered free cashflow and we multiply the last cashflow by one plus the growth rate.
To calculate the terminal value, we simply take this cash flow and divide by the discount rate which is WACC, minus the growth rate.
And this gives me a terminal value of 293.9 million.
Needless to say, this number needs to be discounted. So, I'll take the number and divide by one plus the discount rate, which is in cell D193, all to the power of the year minus 2015. Which is in cell G153.
And this tells me that my discounted terminal value is 184.9 million.
If I compare this number to the discounted cash flows in the first 5 years, I can see that roughly the discounted terminal value contributes about 75% to the total value of the business.
In a typical 5 year projection, the terminal value comprises of 70 to 80% of the total value of the company.
So this current projection appears pretty reasonable. For a 10 year projection, the terminal value will contribute only 50% of the total value. In either case, the terminal value has a huge impact on the final evaluation number. Personally, I'm not a big fan of assuming a constant growth rate from year 6 onwards of 1.5% when calculating my terminal value. As you can see from the growth and annual unlevered free cashflow, this number of 1.5% is simply not viable. Instead, I prefer a more intuitive option for calculating the terminal value called the exit multiple. The exit multiple applies a market-based multiple to the business at the end of the five-year projection. And this multiple is then discounted back to the present day value. So, in effect, we use a discounted cash flow for the first 5 years of future cash flows, and then a market based multiple to estimate the value of the remaining cash flows. In the next lesson, I'll show you how to calculate the terminal value using this method and also implement a switch which allows us to switch between the two terminal value calculations as we wish.