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Microsoft PowerPoint - Terminal Value.pptx WEEK 11 A F I N 8 3 8 Terminal Value (TV) Learning Objectives Estimation of the Terminal Value (or Continuing Value); Length of the forecast period before stable growth; How to estimate the growth rate during the stable growth period; How to estimate the reinvestment needs of the company in the stable period; How does the company’s Return on Investment (ROI) change in stable growth; How to adjust the company’s Capital Structure and Beta in stable growth; Putting all Together. Inputs to Discount Cash Flow Valuation 3 There are 4 inputs that are required to value any asset in these models: I. Appropriate discount rate given the riskiness of these cash flows (Lectures 6-7) II. Estimating cash flows (Lectures 8-9) III. Estimating growth rates in cash flows (Lecture 10) IV. Terminal Value (Today) Reading Material This Week: Textbook: Damodaran on Valuation: Chapter 5: Equity Discounted Cash Flow Models (pages 157–192) Chapter 6: Firm Valuation Models (pages 193–230) Prologue to Valuation In the traditional Dividend Discount Model, you can express the Value of Equity (V(Equity)) of a company as the sum of two components: This can be expressed more elegantly as follows: Last Lecture This Lecture There are three ways of Estimating the Terminal Value (TV) Example: E(VLiquidation)= =BV(Assets)Stable (1+π) AverageLifeAssets Example: E(V(E)Stable)= =E(NetIncome)Stable *(P/E)Today But: Accounting Numbers today How can we estimate the terminal value? If you are doing an intrinsic valuation, which of the following is never an appropriate way to estimate terminal value? Liquidation value Stable growth model (assume stable growth perpetuity) A growing annuity (say 30 years after your terminal year) Exit multiple Terminal value with NO growth You are estimating the terminal value for a firm with $ 100 million in after-tax operating income (and after-tax cash flow) with no growth expected in perpetuity. It has a cost of capital of 10%. Estimate the terminal value. TV= Terminal Value with growth Now assume that you expect the firm to generate 2% in growth rate forever. What will happen to the terminal value? a. It will go up b. It will go down c. It will not change d. None of the above e. Any of the above Help: Assume that the ROC = 4%. There are 5 crucial points to consider when computing the Terminal Value 1. Length of the forecast period: When is the company entering the stable growth phase? 2. What is the (maximum) growth rate during the stable growth period (gSTABLE_GROWTH)? 3. What are the company reinvestment needs in the stable growth period? 4. What happens to the company’s Return on Investment (i.e., ROE or ROC)? 5. What happens to the company’s Capital Structure and Beta? 1) Length of the Forecast Period Assume that you are valuing a young, high growth firm with great potential, just after its initial public offering. How long would you set your high growth period? < 5="" years="" ="" 5="" years="" ="" 10="" years="" ="">10 years What high growth period would you use for a larger firm with a proven track record of delivering growth in the past? 5 years 10 years 15 years Longer Do not wait to0 long to put your company in a stable growth. Why? 10-year of high-growth should be your upper bound. A 10-year growth is the case of companies like Facebook or Linkedin today; Although it seems over- conservative, remember that we are already assuming that these companies are those in the 98th percentile of prolonged growth; It is possible that you company will be the next Microsoft, Google, or Wal-Mart, but we cannot value all growth companies on the presumption that they will all be the next star companies Why is the length of forecast period so important? The stable growth rate cannot exceed the expected growth rate of the economy but it can be set lower; As a general rule: where Since In the long term: which implies that: As a result: 2) What is the (maximum) gStable-Growth? Effect of gStable on Terminal Value ( ) a) If you assume that the economy is composed of high-growth and stable-growth firms, the growth rate of the latter will probably be lower than the expected growth rate of the economy; b) The stable growth rate can also be negative. In this case, the terminal value will be lower which implies that your firm will disappear over time; c) If you use nominal cash flows and discount rates, the growth rate should be nominal; 2) What is the (maximum) gStable? Further Considerations… Source: Compustat; McKinsey Corporate Performance Centre d) If the company is operating domestically, then expected growth rate of the domestic economy will be your upper bound. If the company operate internationally, then the expected growth rate of the global economy will be the limiting value; e) If the cash flows are expressed in a high- (low-) inflation currency then your expected growth rate will be higher (lower) to reflect the expected inflation level. 2) What is the (maximum) gStable-Growth? Further Considerations… 3) What are the company reinvestment needs in the stable growth period? Last week we discussed the drivers of expected growth: However, in stable growth you cannot count on efficiency delivering growth (why? because efficiency is finite as the operating margin cannot be >100%). So, what is the driver of gStableGrowth? Reinvestments!!! In order to generate growth (even if gStableGrowth≤ geconomy) you have to reinvest to deliver this growth rate. Consequently, your reinvestment rate in stable growth will be a function of: (1) your stable growth rate, and (2) what you believe the firm will earn as a return on capital in perpetuity: 3) What are the company reinvestment needs in the stable growth period? (cont’d) Now we are ready to write the equation of the Terminal Value (to all claim-holders): Since the Reinvestment rate depends on both gStableGrowth and ROCn in the stable period, then: If your ROCn > WACCn , increasing gStableGrowth will increase the Terminal Value If your ROCn < waccn="" ,="" increasing="" gstablegrowth="" will="" decrease="" the="" terminal="" value="" ="" if="" your="" rocn="WACCn" ,="" increasing="" gstablegrowth="" will="" not="" affect="" the="" terminal="" value="" example="" alloy="" mills="" o="" industry:="" textile="" industry;="" high-growth="" phase:="" o="" ebit(1-t)="$100m" (today)="" o="" roc="20%" (today)="" o="" ∆="50%" (today)="" o="" wacc="10%" o="" ∗="" 20%*50%="10%" o="" duration="" high="" growth="5" years="" stable-growth="" phase:="" o="" 5%="" o="" e(roc)="20%" o="" ⁄="" 25%="" example="" alloy="" mills="" (cont’d)="" stable="" phase="" rr="" gebit(1-tc)="" ="" case="" #1:="" roc="" (20%)=""> WACC (10%) Case #2: ROC(10%) = WACC(10%) Example Alloy Mills (cont’d) High Growth Stable Growth [1] ROC 20% [5] E(ROC) 20% [2] WACC 10% [6] E(WACC) Retail 10% [3] gHigh = [1]*[4] 10% [7] E(gStable) 5% [4] RR 50% [8] E(RR) =[7]/[5] 25.00% Time 0 1 2 3 4 5 6 PV(TV)(in year 5) EBIT(1-t) $100.00 $55.00 $60.50 $66.55 $73.21 $80.53 $169.10 $2,536.55 PV(today) $50 $50 $50 $50 $50 --- $1,575 Value(Firm) $1,825 High Growth Stable Growth [1] ROC 20% [5] E(ROC) 10% [2] WACC 10% [6] E(WACC)Retail 10% [3] gHigh = [1]*[4] 10% [7] E(gStable) 5% [4] RR 50% [8] E(RR) =[7]/[5] 50.00% Time 0 1 2 3 4 5 6 PV(TV) (in year 5) EBIT(1-t) $100.00 $55.00 $60.50 $66.55 $73.21 $80.53 $169.10 $1,691.04 PV(today) $50 $50 $50 $50 $50 --- $1,050 Value(Firm) $1,300 Example Alloy Mills (cont’d) Case #3: ROC(5%) < wacc(10%)="" high="" growth="" stable="" growth="" [1]="" roc="" 20%="" [5]="" e(roc)="" 5%="" [2]="" wacc="" 10%="" [6]="" e(wacc)retail="" 10%="" [3]="" ghigh="[1]*[4]" 10%="" [7]="" e(gstable)="" 5%="" [4]="" rr="" 50%="" [8]="" e(rr)="[7]/[5]" 100.00%="" time="" 0="" 1="" 2="" 3="" 4="" 5="" 6="" pv(tv)="" (in="" year="" 5)="" ebit(1-t)="" $100.00="" $55.00="" $60.50="" $66.55="" $73.21="" $80.53="" $169.10="" $0.00="" pv(today)="" $50="" $50="" $50="" $50="" $50="" ---="" $0.00="" value(firm)="" $250="" question="" 1.="" calculate="" the="" terminal="" value="" given="" the="" following="" data.="" company’s="" ebit="" in="" $millions="" is="" 1,000;="" gross="" capital="" expenditure="" is="" 200,="" depreciation="50," increase="" in="" working="" capital="100" and="" tax="" rate="" is="" 30%.="" assume="" total="" capital="10,000" as="" funded="" by="" 40%="" debt,="" the="" risk-free="" rate="" is="" 4%,="" pre-tax="" cost="" of="" debt="5%" and="" company’s="" beta="1.2." risk-premium="6%." question="" 1.="" calculate="" the="" terminal="" value="" given="" the="" following="" data.="" company’s="" ebit="" in="" $millions="" is="" 1,000;="" gross="" capital="" expenditure="" is="" 200,="" depreciation="50," increase="" in="" working="" capital="100" and="" tax="" rate="" is="" 30%.="" assume="" total="" capital="10,000" as="" funded="" by="" 40%="" debt,="" the="" risk-free="" rate="" is="" 4%,="" pre-tax="" cost="" of="" debt="5%" and="" company’s="" beta="1.2." risk-premium="6%." solution:="" step1="" :="" wacc="" ="" re="Rf" +="" β(rm-rf)="4%" +(1.2="" x6%)="11.2%" ="" wacc="[11.2%" x="" 60%="" ]="" +="" [5%="" x="" (1-30%)="" x="" 40%]="8.12%" step="" 2:="" g="" ="" roc="EBIT" (1-t)/="" tc="1000" x="" (1-30%)/10000="7%" ="" rr="(capex-depn" +="" wc)/="" operating="" income="" after="" tax="[(200-" 50)="" +100]/="" [1000="" x(1-30%)]="250/700=0.357" ="" g="RR" x="" roc="0.357" x="" 7%="2.5%." since="" g="">
0 and you expect your company to reinvest to maintain its assets, then CAPEX>Depreciation because the fixed assets’ replacement cost will grow at the E(inflation) rate. This implies that gStable >0 Obviously, it is possible that gStable = 0, but you need to carefully check whether this is the case for your company. 4) What about the company’s Return on Investment (i.e., ROE or ROC)? A key issue in valuation is whether it is okay to assume that firms can earn more than their cost of capital in perpetuity. Contrary to many investment