Hi WSO,
I've seen some differences in DCF models using an exit multiple to calculate terminal value. Let's say using LTM multiples and for a 5-year DCF, some multiply the EBITDA from year 5 while other multiply the EBITDA from year 6 (or grow the EBITDA once more to a "terminal year").
Can someone provide clarification on which one to use and the reason behind it?
What's an exit multiple?
Thanks!
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You can use either but have to discount it to whichever year you use.
At least for a growing company, year n+6 should have higher EBITDA than year n+5. But that doesn't necessarily inflate the valuation because the discount factor is compounded by another year.
Someone please correct me if I'm wrong, but I'm not sure that there is necessarily a 'right' or 'wrong' one to pick. When you consider what I said in the first part of my comment, the difference is pretty nominal anyway. Plus, the precision implied by choosing one over the other is unjustifiable, since the model is bound to be inaccurate somewhere over a 5 year period.
That said, I would still probably use the earlier year (year 5 in your example). The further out you forecast, the wider the margin of error is, due to the model's reliance on assumptions being compounded every year. Because of that, year 5 EBITDA is somewhat more accurate that year 6.
To clarify - for the ones I've seen, the exit value calculated from year 6 or "Terminal Year" is not discounted at year 6 but rather added to the year 5 cash flows.
With a DCF, a terminal value is used to determine the value of the entity beyond the forecast period, into perpetuity. Thus, unlike an LBO where you are exiting the business with your terminal value (and using an exit/control multiple), in a DCF, one should use a comparable trading multiple (because public comps don’t have control built in). And this is why you see some people forecast another year - because the trading multiples generally are forward multiples. But some choose to do as mentioned above and apply the current year trading multiple to the year 5 metric. Hope that helps
Oh...And by applying a forward multiple to a 6th year, you are valuing at the end of year five so no need to discount for six periods.
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