Hello!
Really hoping for advice here. I can't figure out for the life of me why I'm getting a negative implied perpetual FCF growth rate. I'm a new user so I can't link the spreadsheet or send screenshots but any guidance would be great!
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Assuming you are calculating terminal value with an exit multiple, e.g. EV/EBITDA, a negative implied growth-rate-in-perpetuity means that the discounted terminal value calculated with an exit multiple is lower than what the terminal value would be if FCF were to stay constant in perpetuity. In other words, your valuation via exit multiple is implying that FCF will decrease in perpetuity. This is the interpretation assuming your formula is correct, so check that first.
That is the mathematical explanation. If your perpetuity growth is negative then the discount rate is further amplified in your terminal value. However, a negative perpetuity growth implies that at some point, maybe a hundred years forward, your company is negative FCF. Intuitively it makes no sense. Mathematically it works out because that negative FCF is discounted by compounding to a number very small so as to keep the overall TV positive. However, you should probably check your exit multiples to see if your comp set is truly accurate/representative. The perpetuity growth is usually >0.5% and academically should be between inflation and GDP rates. If you get a negative rate number it almost surely implies that your comps are on the lower end of valuation, and you are being too conservative.
Not true that they should all grow between inflation and the economy as a whole. Not all firms will have cash flows into perpetuity, and modeling in a firms decline is perfectly acceptable. One example is a biotech company who is losing patent protection. Another could be a tobacco company.
Modeling in a negative growth rate for firms in dying industries is underutilized in my opinion and leads to overvaluation. For “cash cow” companies focused on milking their legacy products and returning capital to shareholders, they can still be a perfectly good investment even with this consideration.
Think about what a negative perpetuity rate means. It means that at some point you will be FCF negative, and then for all years after that, you will be FCF negative. You would use a DCF for this type of company? No, you’d use a comps, because that company either recovers, goes distressed and into bankruptcy/liquidation, or gets acquired. This directly applies to your biotech or tobacco examples. DCFs are used for going concerns...that’s the whole idea behind perpetuity cash flows. If you have a company with temporary negative FCF then you’d not use a DCF because the perpetuity applies on stabilized FCF, not some temporary recession. Best bet: use comps and take 25th percentile, or devise a customized model.
It’s perfect fine if the company is in a declining industry or its business model will cease to exist down the road.
I believe a DCF is premised on FCF being positive eventually into the future, not negative. I think OP would use comps for this case, as DCF doesn’t make sense.
It's because you exit multiple is too low.
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