How to Pick the Terminal Multiple to Calculate Terminal Value in a DCF

• published: 23 Dec 2014
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http://breakingintowallstreet.com/biws/ http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-07-Terminal-Multiple-DCF.xlsx http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-07-Terminal-Multiple-DCF.pptx http://youtube-breakingintowallstreet-com.s3.amazonaws.com/107-07-Terminal-Multiple-DCF.pdf You’ll learn how to select a Terminal Multiple for use in a DCF in this lesson, including how you can check the long-term Free Cash Flow growth rate implied by the Terminal Multiple, how to use data from the comparable public companies, and how to draw conclusions about your analysis with these formulas. Table of Contents: 2:16 Why Most Sources Get This Explanation Wrong 6:33 How to Determine the Growth Rate Implied by a Terminal Multiple 14:46 How to Use the Implied Growth Rate in a DCF 17:09 Conclusions From This Analysis 20:03 Summary Lesson Outline: How Do You Pick the Terminal Multiple in a DCF? Idea: For the Terminal Value, you need to estimate the company's value in the "far future" period… what are all those cash flows worth if you go past Year 5 here, or if you go past Year 10 in a 10-year model? Two methods: the Multiples Method, where you assign an EBITDA multiple to the final year EBITDA, assume the company gets sold, and value it like that; or the Gordon Growth or Perpetual Growth or Long-Term Growth Method, where you assume it operates indefinitely. Need to make sure both methods make sense by themselves, and that the implied multiple and the implied growth rate from both methods seem reasonable. The Multiples Method – Selecting a Multiple You might START by getting the median EBITDA multiple or range of multiples from the set of public comps, and then applying them to this company’s appropriate figure in the final projection year… BUT… You generally want to assume a discount over historical multiples, and even over forward multiples. Why? 1. Multiples generally decline over time as companies get bigger and growth slows down, so investors won't pay as much. 2. The "Terminal Multiple" must imply a reasonable Terminal Growth Rate… if you get something like a 10% FCF growth rate implied by your Multiple, you should be VERY suspicious - no company has ever grown at that rate for decades! (Of course, this also depends on the discount rate - with a higher discount rate, higher growth might be justified.) 3. You also care more about the RANGE of Terminal Values and implied Enterprise Values from a RANGE of reasonable multiples (ex: 25th to 75th percentile of comps, modestly discounted). How do you get the implied Terminal Growth Rate from a Terminal Multiple? Implied Terminal Growth Rate = (Terminal Value * Discount Rate – Final Year FCF) / (Final Year FCF + Terminal Value) Derivation: Please see the PowerPoint slides or PDF at the top. You start out with the familiar Terminal Value formula, Final Year FCF * (1 + Growth Rate) / (Discount Rate – Growth Rate), and then use algebra to get the Growth Rate on one side of the equation. You have to go through a few steps to do this, but it’s fairly simple algebra. How do you decide if this is an “appropriate” implied Growth Rate? It should ideally be LESS than the GDP growth rate of the country this company is in, which means a very low percentage in most developed countries (e.g., less than 3% in the US) because all companies slow down to the rate of growth of the overall economy, or less, in the long-term. You could also look at the expected long-term FCF growth rates of comparables, or the growth rates implied by their multiples. Some people also use other macroeconomic indicators like the inflation rate as a guideline. Conclusions From This Analysis: The baseline multiple of 5.9x we used isn't "wrong" necessarily, but we should probably project further into the future and create a 10-year DCF because the NPV of the Terminal Value comprises over 70% of the total implied value right now – it should ideally be ~50% or less. We should also probably pick narrower ranges for these tables – 4.5x to 8.5x is too wide a range and may not even be meaningful. And… the company was almost certainly overvalued at the time we did this analysis, since nearly all the values were below the current share price of $17.87. We only get values above $17.87 if the assumptions are *very* optimistic, indicating that the company is overvalued or that our assumptions such as the discount rate are incorrect.