Calculate the Terminal Value
Having estimated the free cash flow produced over the forecast period, we need to come up with a reasonable idea of the value of the company's cash flows after that period - when the company has settled into middle-age and maturity. Remember, if we didn't include the value of long-term future cash flows, we would have to assume that the company stopped operating at the end of the five-year projection period.
The trouble is that it gets more difficult to forecast cash flows over time. It's hard enough to forecast cash flows over just five years, never mind over the entire future life of a company. To make the task a little easier, we use a "terminal value" approach that involves making some assumptions about long-term cash flow growth.
Gordon Growth Model
There are several ways to estimate a terminal value of cash flows, but one well-worn method is to value the company as a perpetuity using the Gordon Growth Model. The model uses this formula:
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)
(Discount Rate – Long-Term Cash Flow Growth Rate)
The formula simplifies the practical problem of projecting cash flows far into the future. But keep in mind that the formula rests on the big assumption that the cash flow of the last projected year will stabilize and continue at the same rate forever. This is an average of the growth rates, not one expected to occur every year into perpetuity. Some growth will be higher or lower, but the expectation is that future growth will average the long-term growth assumption.
Returning to the Widget Company, let's assume that the company's cash flows will grow in perpetuity by 4% per year. At first glance, 4% growth rate may seem low. But seen another way, 4% growth represents roughly double the 2% long-term rate of the U.S. economy into eternity.
In the section on "Forecasting Free Cash Flows", we forecast free cash flow of $21.3 million for Year 5, the final or "terminal" year in our Widget Company projections. You will also recall that we calculated The Widget Company's discount rate as 11% (see "Calculating The Discount Rate"). We can now calculate the terminal value of the company using the Gordon Growth Model:
Widget Company Terminal Value = $21.3M X 1.04/ (11% - 4%) = $316.9M
Exit Multiple Model
Another way to determine a terminal value of cash flows is to use a multiplier of some income or cash flow measure, such as net income, net operating profit, EBITDA (earnings before interest, taxes, depreciation, and amortization), operating cash flow or free cash flow. The multiple is generally determined by looking at how comparable companies are valued by the market. Was there a recent sale of stock of a similar company? What is the standard industry valuation for a company at the same stage of maturity?
In Year 5, the Widget Company is expected to produce free cash flow of $21.3M. Multiplying this by a projected price-to-free cash flow of 15 gives us a terminal value of $319.9M.
Widget Company Terminal Value = $21.3M X 15 = $319.9M
You will see that the terminal value can contribute a great deal to total value, so it is important to use an exit multiple that can be justified. One way to make the multiple more believable is to give estimates on the conservative side. Justifying a multiple of 15 with your figures would certainly be easier to justify than one at 20 or 25. Because it can be tricky to justify the multiple, this method isn't used as much as the Gordon Growth Model.
Now you have the following free cash flow projection for the Widget Company.
Terminal Value (Gordon Growth Model)
Free Cash Flow
To arrive at a total company value, or enterprise value (EV), we simply have to take the present value of the cash flows, divide them by the Widget Company's 11% discount rate and, finally, add up the results.
Therefore, the total enterprise value for The Widget Company is $265.3 million.
EV = ($18.5M/1.11) + ($21.3M/(1.11)2) + ($24.1M/(1.11)3) + ($19.9M/(1.11)4) + ($21.3M/(1.11)5) + ($316.9M/(1.11)5)
EV = $265.3M
Calculating the Fair Value of Equity
But we are not finished yet - we cannot forget about debt. The Widget Company's $265.3M enterprise value includes the company's debt. As equity investors, we are interested in the value of the company's shares alone. To come up with a fair value of the company's equity, we must deduct its net debt from the value.
Let's say The Widget Company has $50M in net debt on its balance sheet. We subtract that $50M from the company's $265.3M enterprise value to get the equity value.
Fair Value of Widget Company Equity =
Fair Value of Widget Company = $265.3M - $50M =$215.3M
So, by our calculations, the Widget Company's equity has a fair value of $215.3 million. That's it - the DCF valuation is complete.
Having finished the DCF valuation, we can judge the merits of buying Widget Company shares. If we divide the fair value by the number of Widget Company shares outstanding, we get a fair value for the company's shares. If the shares are trading at a lower value than this, they could represent a buying opportunity for investors. If they are trading higher than the per share fair value, shareholders may want to consider selling Widget Company stock.
You are familiar with the mechanics of DCF analysis and you have seen it applied to a practical example; now it's time to consider the strengths and weaknesses of this valuation tool. What makes DCF better than other valuation methods? What are its shortcomings? We answer those questions in the following section of this tutorial.
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