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Terminal value is generally the largest component of value and esOmaOngit correctly is a key to a good valuaOon.Value = CFt(1+r)tt=1t=∞∑128Value = CFt(1+r)t+Terminal Value(1+r)Nt=1t=N∑
129Ways of EsOmaOng Terminal ValueTerminal ValueLiquidation ValueMultiple ApproachStable Growth ModelMost useful when assets are separable and marketableEasiest approach but makes the valuation a relative valuationTechnically 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
130Gewng Terminal Value Right1. Obey the Growth Gap¨When a firm±s cash ﬂows grow at a constant rate forever, the presentvalue 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 rateNote that g must be < r, or the terminal value will be negaOve.¨The constant growth rate cannot exceed, but can be lower than, thegrowth rate of the economy. If you assume that the economy iscomposed of high growth and stable growth firms, the laZer will probablygrow slower than the economy. The stable growth rate can be negaOve.The terminal value will be lower and you are assuming that your firm willdisappear over Ome.¨One simple proxy for the nominal growth rate of the economy is thecurrent risk-free rate.130
1312. The length of the growth period is linked tothe company’s compeOOve advantage¨Length of growth period - Sustaining high growth is muchmore diﬃcult than sustaining ROIC, especially for largercompanies.¨Companies struggle to maintain high growth because productlife cycles are finite and growth gets more diﬃcult ascompanies get bigger.¨It is not growth per se that creates value but growth withexcess returns (ROIC > WACC). And a company can generategrowth with excess returns only if it has compeOOveadvantages. The stronger and more sustainable thecompeOOve advantages, the longer a company can sustain“value creaOng” growth.131
1323. Don’t forget that growth has to be earned¨Recall the fundamental equaOon for growth:Growth rate = Reinvestment Rate * ROIC + Growth rate fromimproved eﬃciency (if any)¨In stable growth, you cannot count on eﬃciency deliveringgrowth (why?) and you have to reinvest to support theconstant growth rate. Consequently, the reinvestment ratein stable growth will be a funcOon of the stable growth rateand the ROIC:¤Reinvestment Rate = Stable growth rate/ Stable period ROIC¨It is reasonable to assume that the ROIC of companieswithout any sustainable compeOOve advantage will approachthe cost of capital. However, companies with sustainablecompeOOve advantage should be able to maintain a ROIChigher than the cost of capital.