The Theory Behind The Terminal Multiple (Question)
So we all know that when performing a DCF there are two main methods to use when concluding on a terminal value, the Gordon Growth Model and the Terminal Multiple model. The Gordon Growth model is taking the FCF in the final year of the projection period, multiplying it by 1 plus the "constant growth rate" and dividing that product by the difference between the the subject company's WACC and the "constant growth rate." Expressed mathematically:
TV = (FCF x (1 + g)) / (WACC - g)
The strongest assumption the analyst is making when using Gordon Growth to project the terminal value is the value of g, as it is pretty difficult to conclude on a rate that a company's FCFs will grow at into perpetuity. I understand the mechanics of this method pretty well, where I run into trouble is understanding the logic behind the Terminal Multiple Method.
I know that EBITDA or revenue (if EBITDA is negative) is what is being multiplied and that the multiple is selected based on the multiples of publicly traded companies that you have deemed to be comparable to the subject company. A statistical analysis of the the comparable company multiples is usually performed so the analyst can see the min, max, average, and quartiles of the multiples. What I don't understand is how exactly a specific multiple (or range of multiples) is selected based on the comp's multiples. I also don't understand why it would even make sense to apply comp multiples, which are collected from the present time, to the subject company's EBITDA or revenue at a time so far into the future. Any help input on the rationale behind this would be greatly appreciated.
Cheers.
In short, there is a reason why this method is not highly utilized. It is not very accurate. Also, keep in mind if you are projecting anything longer than 5 years, the TV isn't going to tip the scales very much.
So that's the reality of it, but you asked about logic, not reality. Just as a comparable company analysis functions, a company is relatively worth a multiple of its asset or cash flow, as evidenced by publicly traded ranges in the industry. Again as with CCM's, the multiple varies by industry, but I have seen EBITDA used most commonly. At the valuation shops I've worked at, and as stated in Duff & Phelps Cost of Capital, the median is usually the most logical choice.
You hit a good point though, multiples vary throughout time and there has been good studies on both P/e and EV multiples in relation to market dynamics etc. I am sure you could but some analytics around this and perhaps make more accurate assumptions, but at the end of the day you are running this analysis not to determine what the value is, but to show your client something. Banking to sell or buy. Valuation usually for tax-based reasons.
It's an art not a science and the variation in valuation makes it more useful. By over-complicating it you may start to lose some of that utility.
I appreciate the input realjackryan. Understanding why you are doing the valuation in the first place definitely helps clear this up.
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