When we buy a company, we dream that the company’s high growth rate will live on forever. Unfortunately, that is not a reality unless you are Amazon. For the rest of us, facing that reality means utilizing a terminal value with the Gordon growth model as our best means to an end.
Did you know the biggest value in our discounted cash flow is the terminal value? It’s true, and unfortunately, that is where most valuations go off the rails because they either use a highly optimistic growth rate in perpetuity or resort to multiples as the answer.
We can’t estimate future cash flows forever, and we must impose a forced closure by stopping our cash flows at some point in the future, usually five or ten years. Then depending on the company’s status, we determine a terminal value of those cash flows in the hope of determining intrinsic value.
The terminal value calculation remains arguably the most important decision when determining intrinsic value, but analysts often consider it an afterthought. Choosing the correct terminal growth rate has a tremendous impact on our final intrinsic value, and this article will offer some thoughts on how to close that gap.
In today’s article, we will learn:
- What is the Terminal Value?
- What are the Three Methods of Calculating Terminal Value?
- How to Calculate Terminal Value with the Gordon Growth Model
Let’s dive in and learn more about the terminal value calculations using the Gordon growth model.
What is Terminal Value?
According to Investopedia:
“Terminal value (TV) is the value of a business or project beyond the forecast period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.”
As I mentioned earlier, the terminal value determines the value of any company into the future beyond any set period, typically five to ten years.
Analysts use the discounted cash flow models to find the intrinsic value of a business, and a part of that calculation contains two major components:
- The forecast period of the DCF, typically five to ten years
- The terminal value, which extends beyond the forecast period of the DCF
The two most commonly used methods remain the perpetuity growth model or the Gordon Growth Model and the exit multiples, which we will discuss in a moment.
Forecasting cash flows into the future remains murky. Analysts using the discounted cash flows use this model to help them forecast those cash flows, along with certain assumptions or educated guesses to arrive at those values.
The DCF continues as the most popular method used in stock market valuations and corporate acquisitions. The theory is that the asset’s value equals all future cash flows from the asset. We must discount those cash flows back to the present value using a discount rate measuring the cost of capital or required rate of return while taking current interest rates into account.
Suppose you are unfamiliar with how a discounted cash flow model works before proceeding with this article. In that case, I recommend you read through both of the below articles to familiarize yourself before getting into the weeds on these methods.
Once we arrive at the endpoint of our discounted cash flow models, we are at the point where growth will level out and become more stable, and at this point, we need to estimate the cash flows into the future and then discount those back to the present value of money.
The Three Methods of Calculating Terminal Value – An Overview
Once we have finished our discounted cash flow model and arrive at our final year value, the next step is to determine the company’s value, either as a liquidation value, as a value into infinity, or as a going concern.
In this section, I would like to discuss the three methods of calculating a terminal value from the 30,000 feet view.
In some of our valuations, we can assume that the company will stop operations and sell the company assets to the highest bidder. The value of this estimation equals the liquidation value.
There are two ways to determine the liquidation value of a company. The first bases the value of the assets on the book value of those assets, accounting for the impact of inflation. Book value limits this approach as an accounting measure and doesn’t consider any assets’ earnings potential.
The other approach estimates the earnings power of said assets, which would entail a discounted cash flow model arriving at the estimated earnings of the assets. And don’t forget any debt involved in those assets, which must be accounted for before any liquidation.
The first approach, if your company remains a going concern, which means it is a company that will continue after the forecasted period of estimating discounted cash flows, is the multiple approach.
Using the multiple approach requires us to view the assets as a realizable value at the end of the forecast period. Using multiples requires comparing your assets to other assets of relatable companies.
Often referred to as exit multiples, they estimate a fair price by multiplying financial statistics; for example, sales, earnings, or profits.
The terminal value formula using the exit multiples is the most recent metric, i.e., EBITDA, multiplied by the decided upon multiple.
This style of terminal value calculations is common among investment banks and analysts.
While the exit multiple approaches remain simple, the multiple you use greatly impacts the final value, and how you arrive at that multiple remains critical. If we estimate the multiple by looking at comparable companies in the same industry, it ceases to be an intrinsic value calculation. Using multiple comparable causes the terminal value to become a relative valuation, which remained a dangerous mixing of relative valuation and discounted cash flow valuations.
The only way to consistently calculate the terminal value is to apply either the liquidation method or the Gordon Growth Model, which we will discuss next.
Stable Growth Model or Gordon Growth Model
As our company grows, it becomes more difficult to maintain growth. Eventually, the company will grow at a lesser rate and return to earth and grow at a rate equal to or less than the economy the company operates within.
We refer to this rate as the stable growth rate, and the company can sustain the stable growth into forever land or perpetuity, all of which allows us to estimate the cash flows beyond that point as a terminal value.
As companies continue into the future, they can reinvest those cash flows into assets and continue their growth. If we assume those cash flows will grow forever, we can express that value in a formula, such as below:
Terminal Value = Cash Flow / r – g(stable)
In this formula, we need to determine the discount rate depending on whether we value the firm or the equity.
If we value the firm, then the cost of capital or required rate of return and the growth rate of the model is sustainable forever.
Terminal Value = Cashflow to Firm /( Cost of Capital – g )
The above is a version of the Gordon Growth Model, based on the same model you use to value companies that pay dividends. We use it to find the terminal value of a going concern or company sold in the stock market.
Before diving into the calculations, I wanted to touch on the topic of restraints of terminal value in the next section.
Restraints On Terminal Value
Of all the inputs in a DCF, none impact value more than the stable growth rate. Part of the impact is that small changes in the stable growth rate can change the terminal value significantly, with the effects growing larger as the growth rate approaches the discount rate used in the DCF.
Analysts use the stable growth rate to alter the valuation based on their biases.
Because the stable growth rate is a constant forever, it puts strong constraints on how high the rate can go.
Maxim number one when estimating stable growth rates for terminal value.
**”No company can grow forever at a rate higher than the growth rate of the economy in which it operates; the constant growth rate cannot be greater than the overall growth rate of the economy.”**
When considering the stable growth rate of the company, you need to consider what economy the company operates in. Does the company operate in its domestic market, or is it split between the markets?
For example, if the company only operates in the US, then the stable growth rate must be equal to or less than the growth rate of the US economy. And if the company is international, you can consider either the domestic growth rate or a global economic growth rate.
Any choice beyond that will lead to stable growth rates that are wildly enthusiastic.
For example, suppose you estimate your company at the end of the forecast period is going to grow by 6 percent into the future. In that case, eventually, the company will grow larger than the economy it operates in, and if the growth continues, the company will be larger than the global economy.
In other words, growth beyond the economy would lead to Amazon selling you everything from car insurance, toothpaste, cars, homes, and medical procedures. And growth beyond that would mean that everyone in the world would have to buy everything from Amazon.
The point is to choose your terminal stable growth rates with care. The most common choices are either the growth rate of the US economy if you are buying companies here or the 10-year rate on a US treasury; other choices include using the growth rate of the global economy.
While the stable growth rate cannot be higher than the growth rate of the economy, it can be lower, even negative, if the circumstances require it.
Nothing prevents us from estimating a lower stable growth rate, and in many cases, it might be a more reasonable assumption.
Not only is it prudent to have a stable growth rate lower, but a lower rate is a consistent decision as it ensures the stable growth rate will be lower than the discount rate.
A negative stable growth rate is possible; nothing prevents us from using the negative rate. Using a negative rate would indicate the company is liquidating itself over the years and shrinking. When considered logically, a negative rate remains natural for older, more mature companies at the end of their life cycle.
How do We Calculate Terminal Value with the Gordon Growth Model?
Ok, now that we understand how terminal values work and some of the restrictions of the stable growth rates we can use, let’s look at the Gordon Growth Model and how we use the formula to calculate terminal values.
Setting up the formula again:
Terminal Value = (FCF x (1+g) / (d – g)
- FCF = Free cash flow from the last forecasted period
- g = Stable growth rate
- d = discount rate (WACC or required rate of return)
Ok, let’s take a discounted cash flow of a company and then estimate the terminal value of the company. As we go, we will look at the stable growth rate to use in the formula. I won’t rehash the discount or free cash flow growth rates at this point, but I will relay those numbers so you can follow along at home.
The first company I would like to analyze is Amazon; why not?
- Free Cash Flow TTM – $18,736 million
- Growth Rate of Free Cash Flow – 12%
- WACC – 9.04 TTM
So, after calculating the free cash flows over the ten years, we arrive at a final value to find our terminal value.
Our final cash flow estimate for year ten equals $43,801 million
We need to find our stable growth rate and plug those numbers into our formula to find the value.
We have several choices for terminal rates, and I will show three, and we can determine the company’s value based on those rates; that way, we can see the impact those rates can have on the company’s intrinsic value.
Choices for rates:
- 10-year Treasury Bill – 3.11%
- Current Global GDP – (3.6)
- US GDP – (1.6)
Let’s plug in the above numbers to find the different range of terminal values. Remember that these numbers are before we discount those values back to the present and finalize the intrinsic value.
Terminal Value = ($43,801 x ( 1 + 3.11%) / ( 9.04 – 3.11 )
Terminal Value = 45,163 / 5.93%
Terminal Value = $761,602
Now, let’s compare that value to the other choices of stable growth rates.
- Terminal Value Global GDP = $334,316
- Terminal Value US GDP = $424,464
You can see that the negative rates drive down the terminal value and, in the long run, the company’s intrinsic value. Likewise, if I add a stable growth rate of 6%, Amazon would have a terminal value of $1,485,625, which would give us a per-share value of $71.72 with everything else remaining constant.
The intrinsic value of the above companies with their respective stable growth rates:
- 10-year bond rate of 3.11% – $52.50
- Global GDP (3.6) – $41.44
- US GDP (1.6) – $43.36
As you can see, that is a wide range of possibilities concerning the terminal and final value of Amazon. Granted, I am using a fairly conservative growth rate of the free cash flow, considering that Amazon is currently trading at $105+.
Based on the above numbers, the market is building a free cash flow growth rate of roughly 34 percent, way above the level I set for our calculations, but that is a conversation for another day.
Using any discounted cash flow model you like, you can determine the value of any company with that model; the trick is to be consistent with your choice of stable growth rates for the Gordon Growth Model.
A subject not discussed enough in investing is the importance of the price we pay. It has a tremendous impact on your long-term returns and any other decisions you might make along the lines of your investments.
Calculating intrinsic value is part art, part science, but it is vitally important. And understanding the effect terminal value has on those calculations is critical to the final number. For example, if we input the expected growth rate, the market is pricing in for Amazon and offers a 6 percent stable growth rate, your per-share value comes at $6500+!
The above example perfectly illustrates the importance of the terminal value and utilizing the Gordon Growth Model to find the value; the example also exhibits your decisions’ impact on the stable growth rate. A wildly optimistic number not based on reality will create a crazy number.
Investing is all about creating a game plan and being consistent with the plan. Think about the “rules” Warren Buffett talks about repeatedly; they have not changed much in over 50 years. And the ability to stay within himself and stay true to what he believes has helped make him and his shareholders very wealthy.
That will wrap up our discussion today; as always, thank you for taking the time to read this article.
I hope you find something of value on your investing journey, and if you have any questions or if I can assist in any way, please don’t hesitate to reach out.
Until next time, take care and be safe out there,