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# dcfstabl - Closure in Valuation Estimating Terminal Value...

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Aswath Damodaran 1 Closure in Valuation: Estimating Terminal Value Aswath Damodaran

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Aswath Damodaran 2 Getting Closure in Valuation n A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. n Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period: Value = CF t (1+r) t t = 1 t = Value = CF t (1 + r) t + Terminal Value (1 + r) N t = 1 t = N
Aswath Damodaran 3 Ways of Estimating Terminal Value Terminal Value Liquidation Value Multiple Approach Stable Growth Model Most useful when assets are separable and marketable Easiest approach but makes the valuation a relative valuation Technically soundest, but requires that you make judgments about when the firm will grow at a stable rate which it can sustain forever, and the excess returns (if any) that it will earn during the period.

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Aswath Damodaran 4 Stable Growth and Terminal Value n When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate n This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. n While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. n When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.
Aswath Damodaran 5 Limits on Stable Growth n The stable growth rate cannot exceed the growth rate of the economy but it can be set lower. 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 growth rate of the economy. The stable growth rate can be negative. The terminal value will be lower and you are assuming that your firm will disappear over time.

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Aswath Damodaran 6 Growth Patterns n A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions: there is no high growth, in which case the firm is already in stable growth
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