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Terminal Value Formula | How to Calculate Terminal Value in DCF? - YouTube
Channel: WallStreetMojo
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hello everyone hi and welcome to the
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more about this video terminal value
formula watch the video till the end and
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well today we have a topic or that is a
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capital budgeting topic where we are
it's basically valuation but you know
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terminal value formula is a part of
valuations different sort of valuations
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that you do which is the part of the
discounting cash flow again discounting
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cash flow is another subset of valuation
and terminal value formula is something
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what we are going to learn today so
let's begin over here terminal value
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formula is the last cash flow that is
free cash flow upon that is divided by 1
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plus weighted average cost of capital
here summation of 1 I'll teach you how
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exactly it is done so what is terminal
value formula and DCF well see terminal
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value is defined as the value of the
investments at the end of a specific
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period not terminal value formula helps
to estimate the value of our business ok
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it tells you to estimate the value of
the business beyond the explicit
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forecast period so the formula for the
calculation of the terminal value
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formula in DCF is as follow how does it
work FCFF divided by 1 plus WACC that
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is weighted average cost of capital he
over here that I showed you raised to t
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here okay T here is the time we WACC is
weighted average cost of capital or the
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discounting rate and FCFF is the
free cash flow to the firm
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well the terminal value is the present
value of all the future cash flow and it
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is mostly used in the discounted cash
flow analysis now there are three
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methods or so for calculating the
terminal value Formula one is called the
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perpetuity of method second is the exit
multiple method the third is the no
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growth perpetual method we'll start with
the first one
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perpetuity growth method the perpetuity
growth metal method is also known as the
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Gordon's growth perpetual formula okay
so this is the most preferred method in
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this whether you know the assumption is
made that the growth of the company will
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continue and the return of the capital
will be more than the cost of the
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capital that is R will be greater than
the weighted average cost of capital
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that is returned so the terminal value
is calculated as your FCFF of the 6th
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year let's say that is the final year or
around that divided by 1 plus WACC okay
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raise to 6 okay close the bracket and
that will be raised to 6 again this will
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remain the same plus so this will be an
addition to that FCFF 7 raised to 7
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and this hole will be this complete will
be divided by
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this complete will be divided by 1 + WACC
off WACC raise to 7 that is the
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final terminal value the the terminal
discounting rate so if you simplify the
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terminal value formula it will be
terminal value is the simple is that
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FCFF of the 6th year divided by WACC
the growth rate which is the Gordon's
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formula so FCFF can be written as
FCFF 6 is equal to FCFF of 5
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into 1 plus growth rate now use a terminal
value formula in the above equation so
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how will you get the answer so the
terminal value formula will be equal to
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your FCFF of 5 year into 1 plus
growth rate divided by WACC - growth ok
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so you're moving this ahead you're
moving this ahead to the 6th by
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growing got it up your your adding the
growth in that you had WACC divided
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by G so this is your FCFF 6 right but
this method is used for companies which
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is which are mature in the market and
have stable growth example like FMCG
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companies automobile companies and so on
and so forth now let's discuss the
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second one the second is the exit
multiple method what is exit multiple
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multiple method C exit multiple method
is used with the assumption assumption
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of what it is used with the assumption
that the market multiple basis to value
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business and the terminal value can be
the enterprise value divided by your a
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EBITDA or probably your enterprise value
you are
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by EBIT instead of this you can use
your EBIT that is earning before
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interest and tax which are the usual
multiple used in the financial valuation
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so the projected statistics is 11
statistics that is predicted in the
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previous year so the terminal value
formula is equal to last 12 months TVM
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last 12 months terminal multiple in two
projected statistics the third method is
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called the low growth perpetuity model
when the no growth perpetually model is
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used in the industry where a lot of
competition is there and the opportunity
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to earn accessor turn tends to move to
zero right so in this formula the
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assumption is the growth rate and that
is equal to zero this means that the
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return on the investment will be equal
to thee R will be equal to the cost of
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capital okay so the terminal value
formula that is TVF that will be equal
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to FCFF 6 divided by WACC so it is
useful to calculate the GDP of the
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country I'm just giving an example where
exactly this is used now we'll take a
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example of the terminal value formula
right
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I'll show you one template so that that
will be an easy
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let's see some simple to it examples to
calculate the terminal value equation in
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DCF have to understand it better let's
say wind in a metal sector over the
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metal sector let's say it is trading at
10 times the metal sector is basically
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let's it's trading at the 10 times of
thee
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EV/EBITDA term multiple then the
terminal value is 10* EBITDA of the
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company so now let us do the calculation
of the terminal value formula by an
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example suppose let's say your WACC is
10% growth rate is 4 here it
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is G your debit balance is 100 cash is
60 and number of shares is 200
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let me show you so this is how
your table will look like 2015 2016 2017
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numbers then you have your EBIT free
cash flow to the firm and this is how
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you focused it so forecasted EBIT into 1
minus tax that is your you are basically
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deducting your tax this is this will be
a post tax EBIT right
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you add depreciation in that less
Capex change in working capital which
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will give you a FCFF you have been
given your WACC and your growth rate and
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based on this you will have to find per
shared fair value of the stock using the
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two proposed terminal value formula well
using the perpetuating method how things
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will look like the step one is to
calculate the NPV of the free cash flow
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the form to explicit forecast method so
first what we will do after getting all
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this you will calculate NPV NPV of
what your b13 that is your WACC you will
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take into picture and the cash flows
will be from E10 to your forecost all
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your forecost is net present value of the
explicit forecost period right so you'll
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take that which will give you $127 as
your net present value for the period or
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2018 to 2020 step 2 will be to calculate
the terminal value calculation at the
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end of 2018 okay and then you will add
both so the terminal value will be the
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last okay perpetual growth method you
will take the last cash flow 60 *
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1 +
growth rate / WACC - Get the last
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growth rate using the perpetuity growth
method terminal value will be 1040
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and then finally the step 3 the present
value of the explicit FCFF where WACC is
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10% growth 4% so in that
scenario you will add both of them
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perpetual growth method in the terminal
value and then you will calculate the
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NPV of this entire ok with the help of
these WACC that gives you 781 now step 4
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is that you know calculate the
enterprise value and the share price the
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right so the present value of the
explicit FCFF is 127 terminal value is
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781 ad both of them less debt ad cash so
that will give you your equity value
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divided by number of shares that will
give you these share price which is the
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price you were looking for so here you
know that this is an example of terminal
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value contribution to the enterprise
value which is 86% generally the
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contribution is between 82 to 90%
now this is the terminal value using
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exit multiple growth right so same thing
EV /EBITDA simply first after
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exit multiple you have found a your
terminal value with the help of G 3 plus
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G7 G3 plus your depreciation you add
your EBIT plus depreciation in to 7x
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because that is the EV/EBITDA we will
find the terminal value right so based
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on that you can calculate your step
number 3 to calculate the present value
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of the explicit FCFF right-back growth
exit multiple you take the NPV of this
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you will get the present value the if
explicit FCFF and then the
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whole thing remains the same I hope you
have got a fantastic idea how we have
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done things here now what is the
relevance of this relevance of this and
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the uses well use in these financial it
is used in the financial tools like
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Gordon gross method to calculate the DCF
okay
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example same we have seen about and to
calculate the residual method or
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basically to calculate your residuals
earnings so terminal value is an
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important concept in estimating the
discounting cash flow as it accounts
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around 60 to 80% of the
total value of the company special
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attention it should be given in assuming
the growth rate discount rate and the
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multiple like you know p/e
price-to-book ratio PB ratio okay
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PEG ratio and EV/EBITDA ratio
EV/EBIT so there are some of the
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limitation of the terminal value formula
is you know discounting cash flow so if
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you use the exit multiple then we are
mixing the DCF approach with the
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relevant valuation approach as the exit
multiple is arrived from the comparable
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form and you need to note that the
growth cannot be greater than the your
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WACC that is your discounting the rate
always make sure this now the terminal
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value contributes more than 75% of the
total value of this becomes risk ease of
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the value varies a lot with even 1%
change the growth or WACC so the
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terminal value includes the value of the
cash flow even though it is not
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considered in the particular period but
it is difficult to calculate the same
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with other financial model in hence the
terminal value formula is used and
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that's why the terminal value formula is
the value of the company's expected free
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cash flow beyond the period of the
explicit projected financial model I
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hope guys you have got a fantastic idea
about this world of this particular
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topic if you have learned and enjoyed
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