Chapter 18 : Terminal Value

Warren Buffett mentioned that in the "Theory of Investment Value," written over 50 years ago, John Burr Williams set forth the equation for value. I am condensing it here: "The value of any stock, bond, or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

What Is Terminal Value ?

Terminal Value is the value of cash flows post the forecast period to perpetuity and discounting it back with the cost of capital. The Terminal Value generally forms a large part of the valuation of a company. This is the tenth step in the process of valuation.

The prime factors affecting the terminal value are the Non-Operating Profit After Tax (NOPAT), Investment Rate (Fixed Assets and Net Working Capital), Risk-Free Rate, Inflation, Terminal Growth Rate, and Discount Rate (WACC). As mentioned earlier in this section, the free cash flows over the forecast period represent the first part of a company’s value. The Discounted Cash Flow Model values companies as a going concern, thus a company continues to have value post the forecast period. This part of the cash flow (post-forecast period) is called Terminal Value.

Computing Terminal Value

The Terminal Value Model is a geometric series that computes the value of a series of growing future cash flows. It is a derivation of the dividend discount model. The Free Cash flows of the Target Year (FFCT) are multiplied by (1 + Terminal Growth Rate) to arrive at the first year post the forecast period. This value is then divided by the Weighted Average Cost of Capital (WACC), less the Terminal Growth Rate (Cost of Capital - Terminal Growth Rate).

The formula for computing the terminal value is as follows:

Note:

FFCT is the Free Cash Flows in the target year (last year of the forecast period), adjusted for Income Tax assumed in the Terminal Period. Estimating, the target year Operating Profit After Tax, Income Tax, and Investment Rate (Fixed Assets Plus NWC) thus forms crucial parameters in arriving at a valuation

Once we compute the terminal value, we need to multiply this with the discount factor of the last year of the forecast period to arrive at the present value of the terminal value.

Present Value of Terminal Value = Terminal Value x Discount Factor at the end of Forecast Period

Terminal Growth Rate

The Terminal Growth builds in the inflationary growth plus real growth (a steady state). There are three ways in which one may grow the Free Cash Flows during the Terminal Period :

• The Cash Flows to Grow at Inflationary Growth Rate plus Real Growth
• The Cash Flows to Grow only at the Expected Inflation Rate
• The Cash Flows remain constant with zero growth

The Inflationary Growth could be in line with the Long-Term Inflation assumed. This essentially is the pricing power of the company and its ability to keep up with inflation. One should check the history of Inflation of the Currency for the long term

The Real Growth expected into perpetuity should consider the Country's GDP Growth Rate, Industry Growth Rate, and the trend of the World GDP Growth Rate.

You will need to ensure that the Terminal Growth is not greater than the Weighted Average Cost of Capital (WACC) of the Company.

Now that we have defined Terminal Growth, we need to define the WACC during the Terminal Period.

WACC during Terminal Period

WACC Assumptions During Terminal Period

We require the following inputs to compute the WACC during Terminal Period

Expected Inflation Rate

The Expected Inflation Rate should be inflation expectations for the Terminal Period (into perpetuity). The Expected Inflation Rate is for the currency in which the valuation is conducted. Generally, the Risk-Free Rate assumed during the Terminal Period should incorporate the Expected Inflation for the Terminal Period.

The Inflation entered here will be a component in computing the Cost of Debt and Cost of Equity during the Terminal Period.

• Risk-Free Rate

  The Risk-Free Rate is the expected government bond yield for the Terminal Period. A risk-free Rate is defined as an Expected Inflation Rate + Real Interest Rate. Thus, this Risk-Free Rate during Terminal Period should incorporate the Expected Inflation Rate during Terminal Period.

• Income Tax

  We will require the Income Tax Rate expected during the Terminal Period. This should be the Expected Marginal Income Tax Rate in the long term that the company is likely to incur during the Terminal Period (Post Forecast Period).

  In case the Income Tax during the Terminal Period is assumed to be different than assumed during the Forecast Period then one needs to adjust this with Income Tax assumed during the Terminal Period and recompute the Free Cash Flow for the Target Year as this forms the Free Cash flows for the first year of the Terminal Period.

• Debt Equity Ratio

  This is the expected Debt Equity Ratio during the Terminal Period.

• Cost of Debt during the Terminal Period

  This is the Pre-Tax Cost of Debt expected during the Terminal Period. The Cost of Debt should be the Cost of Debt of the Currency in which the company is being valued. The Cost of Debt during the Terminal Period should be consistent with the assumptions of the Expected Inflation Rate and Risk-Free Rate defined during the Terminal Period. One should add the default spread to the Risk-Free Rate assumed during the Terminal Period to arrive at the Pre-tax Cost of Debt.

• Cost of Equity during the Terminal Period

  We will require the Cost of Equity for the Terminal Period. This can be assumed based on Capital Asset Pricing Model (CAPM) or any other model or could just be the implicit return rate of the market or as investors require.

Illustrative Example for Computing Terminal Value for Black Bay Pizza

Continuing with the example of Black Bay Pizza, we now compute the present terminal value for Black Bay Pizza. Table 7 (in Chapter 12: Income Taxes and Net Cash Flow) gives the computation of cash flows. The following important variables are summarized below:

Summary of Variable for Computing WACC during Terminal Period and Terminal Value

1. Free Cash Flows in the 5th Year is 125 (Chapter 12)
2. The Operating Profit in the 5th Year is 343 (Chapter 12)
3. Income Tax is assumed during the Terminal Period to be 25%
4. The Expected Inflation Rate during the Terminal Period is assumed to be 2%
5. Risk-Free Rate during the Terminal Period is assumed to be 2.25%
6. Cost of Debt - Pre-Tax during the Terminal Period is assumed to be 4.5%
7. Debt Equity Ratio is expected to be 25% Debt and 75% Equity during the Terminal Period
8. Expected Market Returns are assumed at 8.9% (2% Inflation Plus 6.9% Expected Return over Inflation).
9. Beta is assumed at 0.75
10. The Cost of Equity computed comes to 7.24%
11. Post Tax Cost of Debt computed comes to 0.84%
12. The Cost of Capital (WACC) computed comes to 6.27%
13. The Discount Factor in Year Five is 0.639
14. Inflationary Growth is assumed at 2%
15. Real Growth is assumed at 2%.
16. Terminal Growth computed (Inflationary plus Real Growth Rate) is 4%

Computation of Terminal Value

Thus, computing the terminal value by applying the following formulae:

PV of Terminal Value = 5726 x 0.639 (Discount Factor in 5th Year) = 3659

I now have the present value of operating cash flows (forecast plus terminal period). Non-operating assets and liabilities are now needed to be added/deducted from the operating cash flow to arrive at the shareholder or intrinsic value of the company