This guide explains how the initial forecast period and terminal value work in DCF valuations. We will start by looking at their use in DCF valuations and move on to further explain both of these concepts. Here are some key takeaways about terminal value and forecast periods in DCF valuations:
To understand terminal value and the forecast period, we first need to understand how to calculate a DCF valuation, and the concept of the time value of money. Here is how a DCF valuation is calculated with e growing perpetuity method:
We will look at this formula in more detail below.
Before we explain terminal value and the forecast period in more detail, we will briefly look at the theory behind discounting cash flows.
The concept of discounted cash flows relates to what someone would be willing to pay today to receive cash flows in the future.
The basic idea is that the sooner someone will receive a future payment, and the more certain they are of receiving it, the more valuable it is today. Money you have today is worth more than an identical amount to be received in the future. Additionally, the risk associated with the possibility of receiving those future cash flows also makes them worth less today.
We call money that we would receive in the future the future value, and the money we would receive today the present value.
When we do a DCF analysis of a business, we’re looking at the business as an asset that will produce future cash flows. We want to discount the expected future cash flows back to their net present value to think about what it would be worth paying in today’s dollars for those future cash flows.
Given what we’ve learned about the time value of money and how we need to give consideration to the fact that it’s worth paying less today for these future expected cash flows, we can now look at how terminal value and our forecast period factor into a DCF valuation.
The forecast period makes up our prediction for the future cash flows we will receive the soonest. Here, we can break these out and give them extra consideration with our model.
Typically, when valuing a business, we will want to forecast out for five years into the future. The idea is that these expected cash flows are from a period when the business will grow faster than it will later on.
This is also useful because some prospective buyers look to buy companies that they can sell again in the future at a profit. Typically, financial buyers operate on a 5- to 7-year time frame, so forecasting out five years makes a lot of sense from this perspective as well.
Often prospective buyers will use debt to finance the purchase of a business and this debt will need to be paid off over the next few years. Many loan products are based on five year borrowing periods.
The key to doing a DCF valuation correctly is ensuring that we use the right cash flows and the right discount rates. We’re using the DCF valuation to give us the enterprise value of the business, and therefore we need to account for the cash flows that are available to all capital providers. Additionally, we need to use a discount rate that accounts for all capital providers as well. To do this, we use the unlevered free cash flows in the numerator, and we discount them back in time at their weighted average cost of capital (r) in the denominator. This gives us consistency in the numerator and denominator. You can learn more about this in our guide: Discounted Cash Flow (DCF) Valuation.
Using the unlevered free cash flows and the weighted average cost of capital as the discount rate will give us the enterprise value of the business. The enterprise value of the business is the net present value of the future cash flows. This tells us what it would be worth paying today for these future cash flows.
The terminal value is used to give us a valuation of all of the future cash flows the business will produce indefinitely into the future. A major assumption with DCF valuations is that companies are a going concern—meaning they intend to operate indefinitely into the future. Another assumption made is that the business we are valuing will grow faster in the initial forecast period (most often five years), than it will in the future. The rationale behind this is that eventually competition will catch up, and the business’ total addressable market could be reached—slowing the growth of the business.
There are two ways that terminal value is calculated. Normally, a DCF model will include both and they are typically placed side by side for comparison purposes. Sometimes an average of the two is taken.
First, we have the growing perpetuity method, which looks at the business as a going concern that will operate indefinitely into the future. Typically very low perpetual growth rates are used as a conservative metric.
Second, we have the exit multiple method, which looks at a financial metric (like EBITDA), and multiplies it by what comparable companies have sold for above that metric. So, if a business sold for 10 times EBITDA, then they would use that precedent sale price as a basis for valuing a similar company.
Next, we will look at both of these methods in more detail.
First, we will look at the growing perpetuity method for calculating the terminal value of the future cash flows the business will produce. This formula is calculated like this:
Previously, we looked at the rationale behind why a business is expected to grow at a faster rate earlier on than it will indefinitely into the future. Mainly, the rationale is that eventually competition will catch up, and the business’ total addressable market could be reached—slowing the growth of the business.
Because of these assumptions, we would normally pick a very low rate for our perpetual growth rate (g). Often the GDP growth rate of the country the business operates in is used.
The idea here is that the business will grow slower here than it did in the initial forecast period. Normally, we look at historical growth over the past few years to create our forecast period projections from that historical data with best, base, and worst-case scenarios. For our terminal value to make sense, we need to show the business growing at a rate that is reasonable to assume, as long as the business is still able to operate competitively.
In addition to the growing perpetuity method, we have the exit multiple method. Here, we look at precedent transactions for comparable businesses that have recently sold and we use the multiple that they sold for above our financial metric to justify a valuation for our business. The exit multiple formula works like this:
The exit multiple method gives us another way to look at terminal value. Here, instead of using a low growth rate (like GDP growth rate), and accounting for indefinite growth, we look at what previous companies have sold for above our metric.
Typically, EBITDA is used as the exit multiple in mergers and acquisitions. So, we could look at precedent transactions and see that similar companies have sold at 10 times EBITDA. In this case if our cash flow was $10 million, then our terminal value of these expected future cash flows would be $100 million.
To better understand the rationale behind this, let’s look at how publicly traded companies are valued. Publicly traded companies have published financials that anyone can look up. To value a publicly traded company, all we have to do is look at the total number of shares outstanding and multiply that by the current stock price. This gives us the company’s market cap—the total value of the company’s stock.
The market values and revalues publicly traded companies every trading day through the current stock price—what investors are willing to pay for shares. This is factual because trades either happen or they don’t. People either buy or sell.
The exit multiple method uses the same logic. If someone was willing to pay a multiple above EBITDA (or a different metric), then the value is justified through the marketplace.
In most cases the financial metrics used are revenue, EBITDA, and earnings. Although EBITDA is the most common method in mergers and acquisitions for private companies.
It should be noted that in order to use the exit multiple method correctly, we need to make sure that the companies are actually similar. If they are not comparable, then the exit multiple will make no sense.