Session 9: Terminal Value
Introduction
In this session, the speaker talks about closure in valuation and how to estimate terminal value.
Closure in Valuation
- All good things come to an end, including high-growth companies and great products.
- To bring closure to the valuation process, you need to estimate cash flows forever.
- However, since you cannot estimate cash flows forever for a publicly traded company, you need to assume that the business will continue beyond a certain point in time. This is called a going concern or a terminal value.
- There are two legitimate ways to get a terminal value: liquidation value and going concern value.
The Importance of Terminal Value
In this section, the speaker emphasizes the importance of terminal value and introduces three approaches used to estimate it.
Approaches Used to Estimate Terminal Value
- There are three approaches used to estimate terminal value: liquidation value, going concern value, and applying a multiple.
- Liquidation value involves shutting down the business at the end of your five-year or ten-year period and selling off its assets.
- Going concern value assumes that your company will keep going after your five or ten years but that its cash flows will grow at a constant rate forever.
- Applying a multiple involves using a multiple (e.g., revenue multiple or earnings multiple) on your five-year or ten-year numbers. This approach should never be used as it is not intrinsic valuation but rather relative valuation.
Rules for Estimating Terminal Value
In this section, the speaker provides four simple rules for estimating terminal value without letting it run away with the evaluation.
Four Simple Rules for Estimating Terminal Value
- Don't exceed the cap - make sure that you don't exceed what's reasonable when estimating growth rates.
- Don't use a growth rate higher than the risk-free rate - if you do, you're assuming that your company is less risky than a risk-free investment.
- Don't use a growth rate higher than the economy - if you do, you're assuming that your company will grow faster than the economy forever.
- Use reasonable assumptions - make sure that your assumptions are reasonable and based on historical data.
Conclusion
In this section, the speaker concludes by summarizing the importance of terminal value and emphasizing the need to estimate it correctly.
Key Takeaways
- Terminal value is an important part of valuation as it captures what happens beyond your five or ten-year period.
- There are three approaches used to estimate terminal value: liquidation value, going concern value, and applying a multiple (which should never be used).
- To estimate terminal value correctly, follow four simple rules: don't exceed the cap, don't use a growth rate higher than the risk-free rate or economy, and use reasonable assumptions.
Using Risk-Free Rate as a Proxy for Growth Rate
In this section, the speaker discusses using the risk-free rate as a proxy for growth rate in the economy and as a cap on terminal growth rate.
Using Risk-Free Rate as a Cap on Growth Rate
- The risk-free rate is an excellent proxy for nominal growth rate in the economy.
- Even if you don't think it's a good proxy, it still makes sense to use it as your cap on your growth rate.
- Don't wait too long to make a judgment about when your company will become a stable growth company.
Factors to Consider When Deciding Growth Period
- Look at the size of your company relative to the market that it serves.
- Look at recent revenue growth rates, not earnings.
- Do some strategic analysis of your company's competitive advantages.
Excess Returns and Return on Capital
- Examine what kind of return in capital you're going to give your company in perpetuity.
- For 80% of companies, set return on capital equal to cost of capital in stable growth.
- When making a company stable, give it characteristics such as lower cost of capital and beta moving towards one.
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