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.
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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.
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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.
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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.