Terminal value is generally the largest component of

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Terminal value is generally the largest component of value and esOmaOng it correctly is a key to a good valuaOon. Value = CF t (1+r) t t=1 t= 128 Value = CF t (1+r) t + Terminal Value (1+r) N t=1 t=N
129 Ways of EsOmaOng 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. 129
130 Gewng Terminal Value Right 1. Obey the Growth Gap ¨ When a firm ± s cash flows grow at a constant rate forever, the present value of the cash flows can be wriZen as: Terminal Value = Free Cash flow at the end of the year/ (r - g) Where, r = WACC; g = constant growth rate Note that g must be < r , or the terminal value will be negaOve. ¨ The constant growth rate cannot exceed, but can be lower than, the growth rate of the economy. If you assume that the economy is composed of high growth and stable growth firms, the laZer will probably grow slower than the economy. The stable growth rate can be negaOve. The terminal value will be lower and you are assuming that your firm will disappear over Ome. ¨ One simple proxy for the nominal growth rate of the economy is the current risk-free rate. 130
131 2. The length of the growth period is linked to the company’s compeOOve advantage ¨ Length of growth period - Sustaining high growth is much more difficult than sustaining ROIC, especially for larger companies. ¨ Companies struggle to maintain high growth because product life cycles are finite and growth gets more difficult as companies get bigger. ¨ It is not growth per se that creates value but growth with excess returns (ROIC > WACC). And a company can generate growth with excess returns only if it has compeOOve advantages. The stronger and more sustainable the compeOOve advantages, the longer a company can sustain “value creaOng” growth. 131
132 3. Don’t forget that growth has to be earned ¨ Recall the fundamental equaOon for growth: Growth rate = Reinvestment Rate * ROIC + Growth rate from improved efficiency (if any) ¨ In stable growth, you cannot count on efficiency delivering growth (why?) and you have to reinvest to support the constant growth rate. Consequently, the reinvestment rate in stable growth will be a funcOon of the stable growth rate and the ROIC: ¤ Reinvestment Rate = Stable growth rate/ Stable period ROIC ¨ It is reasonable to assume that the ROIC of companies without any sustainable compeOOve advantage will approach the cost of capital. However, companies with sustainable compeOOve advantage should be able to maintain a ROIC higher than the cost of capital.

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