Chapter 3: Value

Lecture 3.4: The Terminal Value

 Valuations are mostly made assuming a going-concern situation, that is: the company lasts forever. This
means we virtually need to estimate cash flows forever.
 As a shortcut to doing the formula in an infinite number of periods, we can use a perpetuity formula that
makes our computational job easier

FCFT 1
FCF1 FCF2 rg
Value     
(1  R) (1  R)
1 2
(1  R) T

 But the perpetuity formula IS NOT a miracle worker and should only be used if we understand what we are
doing with it!
 How many years do I need to estimate explicitly before I use the
perpetuity formula?

 This is a WRONG question to ever be asked!

 The perpetuity formula is a mathematical expression that assumes constant cash flows or
constant growth rates in cash flows moving forward. As such, it can only be used whe the
company’s cash flows have effectively stabilized at a certain value creation set-up!
 Knowing when to use the perpetuity expression is a result of your own model and is not an
answer you can know beforehand!
 What growth rate should I plug into my formula?

 The growth rate plugged into the formula is not something that can randomly be inserted into
the model!

 Again, the only thing the perpetuity formula does is saving you time computation wise by
assuming that the last year’s situation will be replicated from that point onwards forever. So the
growht you have in the last year has to be the growth you assume moving forward!
 So I worry about growth but not the return?

𝑭𝑪𝑭 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡 − 𝐶𝑜𝑟𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑉𝑎𝑙𝑢𝑒 = =
𝒓−𝒈 𝑟−𝑔

𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡 − (𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡 × 𝐼𝑅) 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡 × (1 − 𝐼𝑅)

= =
𝑟−𝑔 𝑟−𝑔

𝒈
𝑪𝒐𝒓𝒆 𝑹𝒆𝒔𝒖𝒍𝒕 × (𝟏 − )
= 𝑹𝑶𝑵𝑰𝑪
𝒓−𝒈
Requires the firm (in particular the investment rate) to have stabilized for this to be hold
1. When we want to value a company, the first thing we need to figure out is what are our beliefs about its
steady-state growth rate and RONIC values – more on how to figure this out later on.

2. When we are calculating the free cash flows of the company year after year, we should keep track of how
much g and RONIC are.

3. When these are stable and consistent with our steady state assumptions, we can use the perpetuity to
save us extra computational work – but we cannot do it before that! It takes as long as it takes!

Suggestion: To make sure that you are consistent on your value driver assumptions, use:

𝒈
𝑪𝒐𝒓𝒆 𝑹𝒆𝒔𝒖𝒍𝒕 × (𝟏 − )
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝑹𝑶𝑵𝑰𝑪
𝒓−𝒈