Anyone understand the logic behind the terminal value formula?
I am going through Brian DeChesare's BIWS course and he defines terminal value in this way:
Terminal Value = (Final Year FCF*(1+FCF Growth Rate))/(Discount Rate - FCF Growth Rate)
Can anyone explain the logic behind this? Thank you!
It's just taking FCF and making it a perpetuity, i.e. FCF will keep growing but all future FCFs need to be discounted to PV.
Sometimes an exit multiple is used as well for TV, which is just an EV/EBITDA multiple at the end of your forecast horizon just as if the asset were sold for a cash dollar amount.
Uhhh..thanks for the MS? I guess you must be more well versed in valuation lol
Maybe because it was clear he was referring to the gordon growth method, not the terminal multiple method? Anyway, OP what Texas said is exactly right.
If you want a bit more of an academic explanation (probably beyond what you would need in an interview): Think about what a normal DCF equation looks like, with the addition of a constant growth rate. FCF/(1+Wacc) + FCF*(1+g)/(1+Wacc)^2 + FCF(1+g)^2/(1+Wacc)^3...on to infinity. If you do some factoring and substituting the formula collapses down to what you posted.
What you're describing is the Gordon Growth model for a growing perpetuity, which gives you the PV of a string of payments at regular intervals that lasts forever and grows by a certain factor every time. Obviously, there is an implicit assumption of going concern for the company you're valuing. You first grow the final year cashflow by 1 period because mathematically speaking, the PV formula of a perpetuity values that perpetuity as of T-1.
The derivation of the GGM is below. It's a relatively simple substitution and sum of infinite geometric series to get to that final figure.
https://en.wikipedia.org/wiki/Dividend_discount_model
Don't prove this in an interview. Most people have never seen this before, and you'll get auto-rejected for coming off as too smart / tryhard.
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