Say the CEO of a company has approached your investment bank to sell their company. How would you go about calculating the terminal value in a DCF if the company is private? Would you just project cash flow out for a longer period and omit the terminal value calculation entirely?
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The only difference for doing a DCF for a private co vs. a public co is there is no observable (equity) beta to calculate WACC. So you have to find a way to approximate one. Most common method is to find comparable companies, deleverage their equity beta to find their asset betas, average for industry beta and relever to the private co's cap structure for their implied equity beta.
100% agreed and its a textbook answer that applies to reality as well.
Though I've heard of people building bottom-up betas? I vaguely remember the components of beta being 1. Operational leverage (% of fixed costs), 2. Financial leverage (capital structure) and 3. Nature of the industry. I'm assuming there's some metric people follow or some method people use to calculate bottom up betas? Would love to hear more opinions on this.
Yup, work with a lot of pvt companies and this is what we almost always do.
Gordon growth model and sanity test the implied EBITDA exit multiple
DCF - Terminal Value Issue (Originally Posted: 04/16/2017)
Hi,
I need some help with my DCF in calculating the terminal value. When using perpetuity growth rate, my share price is in reasonable range. However, alternatively, when I use NOPAT/WACC to calculate my TV, the target share price is significantly below the actual share price. Can someone help with this?
Thanks in advance.
Why would you use nopat/wacc? That essentially assumes zero perpetual growth so naturally you'd come to a lower value.
my finance professor instructs us to
It sounds like your professor is trying to teach you the difference in valuation based on earnings power value and valuation assuming accretive growth through reinvestment.
DCF can include growth with a ROIC > WACC which will yield a higher valuation than on earnings power alone.
NOPAT/WACC gives you the earnings power valuation assuming no reinvestment other than maintenance capex (all for a steady-state company). If earnings power valuation is significantly less than the DCF, either (i) the company will continue to have high ROIC reinvestment which makes the company more valuable than on earnings power alone or (ii) the NOPAT is not truly based on steady-state margins and needs to be reassessed.
Your professor is trying to teach you that messing with the growth rate can have severe implications on the value. It's okay if the value comes out significantly lower than the market price -- the market is not assuming a 0% growth.
numerous problems with using a terminal value multiple -- you are mixing fundamental analysis with market pricing.
furthermore, if you cap NOPAT @ WACC you might not be including capex associated with the long-term growth rate. if your DCF doesn't include ROIC, reinvestment rate and WACC = ROIC for terminal value then it is not internally consistent
Absurd that finance professor wouldn't know this
OP -- your question came up in another thread so I created an illustrative model demonstrating why you need all of these assumptions to do a DCF.
Link: https://www.wallstreetoasis.com/forums/valuation-under-discounted-cash-…
While some companies can out-earn their WACC (those with patents / select branded consumer goods / distribution-heavy companies with economies of scale) this is not the norm and you will overpay if you make this assumption. For the companies that have ROIC > WACC there are finite investment opportunities to deploy capital (i.e. the Coca-Cola / Hershey's of the world) so these companies end up paying out much of their excess FCF to stakeholders.
The most straightforward way to think about this is applying any assumption to a 100 year DCF. Imagine if you valued a high-growth company that had robust ROIC and assumed sales would grow faster than the underlying economy. A company with 12.5% sales growth on $1 billion of revenues today would eclipse US GDP by year 100.
Another conceptual point worth making is that growth in sales and the returns on making investments to bring on those sales only adds value if your marginal ROIC > WACC. Some companies may outperform but across an entire sector this should even out in the long run. Again, think about the 100 year extrapolation of a sector having excess returns that could be deployed in value accretive projects in perpetuity.
I'm sorry but you appear to have a misunderstanding on the terminal value section of valuing a company through DCF.
You will always have to calculate the terminal value (through Gordon's Growth or comparable exit multiple) and projecting cash flow out for a longer period of time will just not cut it. This is because longer period of time is not equals to forever. Yes, you might get a pretty close number (depending on how far out you project) but it'll still be wrong because there's a conceptual understanding.
Further to your question, if a CEO approaches your investment bank, that would make them your client? And the easy way would be to ask the management's opinion of growth and use that and apply it to GGM, then a sanity check.
Discounted Cash Flow - Terminal Value (Originally Posted: 11/15/2016)
I am hoping someone can help me.
Say i have a PV of FCF's of £500,000 over 5 years, with the fith year FCF being £100,000.
WACC = 7% Perpetuity Growth = 5% Interest Bearing Debt in current year = £50,000 Cash = £50,000
Using this what is the terminal value?
I get £4,143,177 but i feel it is wrong?.
Many Thanks
5% LTG-rate? tell your professor to wake up.
how are you calculating it?
5% i made up to see if my model works ;)
To calculate the LTG wouldn't you in theory match it to the long term growth of the UK economy (assuming the company only operates within the UK). Depending on how that is calculated, it would just be over 4% i think?
Terminal value is just terminal year FCF x 1+LTG/(r-g). In this case it's 105,000/2%=5.25MM
I think a big issue was i took the IMF GDP forecast and Inflation forecast then adjusted the GDP for the inflation.
I think the GDP growth forecast already takes into consideration inflation?
You don't build a lever into a DCF for inflation. I always start my DCFs with 2% terminal growth rate and adjust as I see fit.
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