Terminal Value and Its Importance

Understanding the impact Terminal Value has on DCF modeling

Apr 24, 2021

Possibly the most time consuming part of creating a Discounted Cash Flow model is spent calculating unlevered free cash flows. Finding these cash flows requires handling over a dozen data points across several years, which can take hours to complete- unless you use DCF Tool which completes this in seconds.

While a lot of time is put into finding the cash flows, terminal value is one quick assumption that can be made in seconds. This also may be the most overlooked part of a DCF calculation- for many companies, terminal value represents over half of the total intrinsic value (final result). Without more consideration for this one input, results can be drastically skewed.

DCF Tool uses a perpetual growth model to estimate the terminal value. In the perpetual growth model, we assume the company will grow at some conservative low rate forever.

The Terminal Value Formula

First, let's review the equation:

$$Terminal Value = \frac{Final Year UFCF * (1 + Terminal Rate)}{Discount Rate - Terminal Rate}$$

In this equation, the difference between the Discount Rate (often the WACC) and the Terminal Rate drives the terminal value. As an example, let's take a company with a low WACC, such as Ford (F). As of this writing, Ford has a Weighted Average Cost of Capital (WACC) of just 3.3%. If we assumed a final UFCF of $5 billion for this example, and a 2% terminal rate (based on historical yield rates), the equation would give: $$TV = \frac{5B * 1.02}{0.033 - 0.02} = 392B$$ At$392 billion, this would be an exit multiple of 78 times the final $5 billion cash flow! In simpler terms this result is the price someone would theoretically pay to buy the company, 78 times the amount it makes in just one year. On its own this result is incredibly unrealistic, Ford would almost certainly not be able to find a buyer at such a high multiple. Going further, if the model projected 5 years of growth rate at an average UFCF of$5 billion per year, the growth phase would total $25 billion* in value. Adding this to the$392 billion terminal value, the terminal value in this example represents 94% of the total intrinsic value! This example clearly shows how significant terminal value can be in DCF modeling.

With such a skewed result, all of the hard work done to find the unlevered cash flows is almost entirely wasted by this one equation.

Sensitivity

To show just how sensitive and therefore important the Discount Rate and Terminal Rate are, let's change the WACC to a discount rate of 2.5%:

$$TV = \frac{5B * 1.02}{0.025 - 0.02} = 1,020B$$

Simply changing the discount rate from 3.3% to 2.5% nearly triples the final terminal value. As the discount rate continues to approach the terminal rate, this gets more and more excessive.

Doing a DCF model is worthless if you don't consider these variables- simply focusing on growth rates isn't enough to accurately model the value of a company. Always consider the difference between the Discount Rate and Terminal Rate when doing an analysis.

DCF Tool is here to help

Historical data suggests that across all industries, an exit multiple above 30 is extremely uncommon, with the average being between 5-15x. That's why our model automatically clips any results above 30x (or a corresponding difference between Discount Rate and Terminal Rate of 3.3%).

This safety is yet another reason to use and trust DCF Tool as your first source for scanning potential investment opportunities.

*For the purposes of this example and to maintain clarity, these values are not discounted to a present value.