Terminal Value (TV) is the estimated present value of a business beyond the explicit forecast period. The terminal value includes all the value of future cash flows outside of a particular projection period. There are two methods used to calculate the terminal value:
Exit Multiple
Gordon Growth Model
Gordon Growth model A.K.A Dividend discount model is the method to value intrinsic price of an underlying stock. This formula invented by Mr. Myron Gordon, who was an American Economist, calculates the present value of all future dividend payments that will be done by the company. Formula for calculating intrinsic value through Gordon growth model is:
Price of the stock= Upcoming dividends/ Cost of capital - Perpetual growth
Let us see one hypothetical example and calculate the intrinsic price of stock.
Here we haven’t explained exit multiple as we have separate blog posts for the same i.e. Valuation post 2, Valuation post 3 and Valuation post 4.
Now let us understands what role does Terminal value plays in valuation:
This means your current valuation of the company is 85% dependent on terminal value. So this is just one example but in many models this number may touch in the range of 70% - 90% and above.
As observed, a major portion of current value depends on terminal value so people in the market always fear that if their terminal value goes wrong then their valuation would go wrong.
Micheal Mouboussin (Read his Bio) once said never ever your terminal value should be more than 50% -60% of your valuation or if it is high then it means your company has much more growth left that you are not forecasting.
Calculating Terminal values through Gordon growth model has two big assumptions: 1) Terminal period WACC and 2) Perpetual growth rate.
The terminal value calculations are very sensitive to both these assumptions. Now although this is common knowledge among analyst community but rarely people understand two critical points regarding this sensitivity on terminal value
The change is not linear -> that is if we change WACC from 4% to 5% and from 5% to 6% the impact on valuations (% change in terminal value) are different and same non-linearity is portrayed by perpetual growth
The impact caused by changing WACC or perpetual growth on terminal value depends on the current level of WACC & perpetual growth.
Now let us understand the trade-off between these two variables (WACC and Perpetual growth) using excel sensitivity tools. Steps to create a brief sensitivity table:
1) Write your assumption on the vertical and Horizontal axis like shown in the below image.
2) Select whole table
3) Go to Data tab > What if Analysis > Data table > Select in Row original perpetual growth cell and select in Column original WACC Cell→ 9.15% (WACC) and 5% (Perpetual growth rate) in our case.
So above is the output of the above data table that shows various intrinsic values of the stock under different WACC & G combinations. The range comes to be 2761-4487 per Share.
Also Check out the below Video for the same:
Now let us understand the non-linearity in % changes in Value due to change in WACC and/or G.
Change of WACC Impact
So as you can see above WACC's impact on valuation is more in the high growth period compared to low growth (perpetual growth rate) period. As in both the scenarios WACC is decreasing by 2% i.e. from 10.15% to 8.15% but valuation increases by 38.18% (from 3247 to 4487) in high growth scenario of 6% whereas the impact on valuations of same 2% decrease in low growth 2% scenario is just 14.12% i.e. from 2761 to 3151.
Also observe the incremental change especially under high growth scenario. When we change discount rate by same 0.5% first from 9.15% to 8.65% valuations increase by 8.88% whereas the impact on valuation id 11.53% when discount rate decreases by further 0.5% to 8.15%.
It implies that further discount rate goes down for high growth stocks more drastic are the valuation increases. This has been one of the most highly debated reason for justifying astronomical valuations (P/E ratio) of high growth tech stocks due to almost 0% discount rates in lot of developed world (We don't agree with this logic we will soon be publishing a post on the same)
Change of Perpetual growth Impact
Similarly above we have analyzed the impact of perpetual growth change under both Low WACC & High WACC scenarios. So from the above table you can see Perpetual growth rate impact on valuation is more when WACC of the company is low compared to high WACC i.e. if growth rate changes from 2% to 6% under high WACC i.e. 10.15% scenario the valuations ONLY increases by 17% (i.e. from 2761 to 3247) whereas under low WACC scenario of 8.15% the valuations increases by 42% (i.e. from 3151 to 4487).
So the main thing to remember from the above analysis is: If you are at a higher WACC, then reducing WACC is a nice strategy compared to increasing growth. And if you are at a lower WACC then increasing perpetual growth would lead you to higher valuation.
The best thing for a business to achieve higher valuation is to lengthen the time period after which it hits perpetual growth i.e. have a long runway for growth. How to measure the long run way of growth we will leave that for another series :) :)