The Key Fundamentals of Valuation
Calculation of cashflows, identifying growth rates and computing discount rates are key fundamentals for the valuation for the company. However, there is one final piece of puzzle that is to be addressed to calculate the terminal value.
The value of the asset or the company is usually the present value of its expected cashflows overtime, but what will happen if a potential asset or a company could have indefinite cashflows? To calculate the future cashflows, a terminal value is computed. Terminal value is the number that is used to capture the future cashflows that are nearly impossible to forecast.
Broadly speaking there are three ways in which the terminal value can be calculated.
Liquidation value: In this method, the plan is to liquidate the business and sell all of the assets. The expected cash flows that will be generated by the sale of the assets can be considered as the terminal value of the company.
Going concern value: The assumption for this method is that the company will continue its operations and its cashflows will grow at a constant rate forever. There are three very simple rules to properly calculate the terminal value through this method.
The growth rate should not exceed the growth rate of the economy. It is always difficult to estimate the future growth rate of the economy. However, the risk-free rate can be used as a proxy for the growth rate in the economy. Even if you consider that risk free rate is not a good proxy it should be used to calculate the terminal value. The reason for that is if you think the risk-free rate is low than automatically your cost of capital will be low. To compensate, it’s better to keep the growth rate low as it keeps the valuation inline.
Judge when the company will become a stable growth company. To find out the growth period, you should consider the size of your company relative to market that it serves. If you have a large company in a mature market, the growth period will be shorter but if you have a small company in a huge market, you can allow for a longer growth period. Secondly, identify growth in revenue over the past two to three years. If there is no significant increase in revenue, then be wary about high growth rates and high growth periods. In majority of the cases the growth period is 3 to 5 years.
Think about excess returns, this means the return on capital that the company will earn in perpetuity. This return of capital might reduce in future because of the competition. In majority of the instances, this return is same as cost of capital in stable operation.
Multiple approach: In this method, the terminal value is calculated by using various multiples such as EBITDA multiple, revenue multiple and others.
The process of arriving at a business' value must include a detailed and comprehensive analysis that includes factors such as, past, present, and future earnings and overall prospects of the company.
In my opinion, the first two methods should be used for the calculation of terminal value as these methods help you to identify the intrinsic valuation of the company rather than relative valuation.