calculate the terminal value in a DCF model

compositional_skills/grounded/science/social_sciences/economics/attribution.txt

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+title_of_work: Terminal Value Step by Step to Understanding Terminal Value (DCF)
+link_to_work: https://www.wallstreetprep.com/knowledge/terminal-value/
+license_of_the_work: free public content
+creator_names: Wall Street Prep authors

compositional_skills/grounded/science/social_sciences/economics/dcf_model

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+version: 3
+task_description: 'Teach the model how to calculate a terminal value in a discounted cash flow model.'
+created_by: crobb1
+seed_examples:
+  - question: How do you calculate the terminal value in a discounted cash flow (DCF) model?
+        answer: Once the growth in your DCF has stabilized, you want to calculate the terminal value. The terminal value summarizes all future cash flows. There are two ways to calculate the terminal value. First, you can use the exit multiples method. The exit multiples method uses some standard financial multiple based on comps to determine what the value of the company is at that point in time. The exit multiples method is calculated with the formula Terminal value = Final Year EBITDA x Exit Multiple. EBIT, free cash flows, etc. can also be used in place of EBITDA. The exit multiples can come from comps, recent transactions, etc. The second way to calculate the terminal value is the growing perpetuity method, which is calculated with the formula Terminal Value = Discounted Cash Flow / (Discount Rate - Growth Rate). An alternative formula that can be used in the growing perpetuity method is Terminal Value = Discounted Cash Flow x (1+ Growth Rate) / (Discount Rate - Growth Rate). The discount rate is your WACC or hurdle rate, and the growth rate is your expected growth rate past your forecast period. Typically, GDP growth rate or the risk free rate are used as the growth rate. The discounted cash flow is the DCF you have for the first year outside of your forecasted cash flows. Both methods can be used, and often analysts will use both together as two views. The exit multiples method is seen as more precise, as it is using actual data from comps. However, the exit multiples method is criticized for bringing relative value into an intrinsic valuation model. The growing perpetuity method may be seen as less precise; however, it maintains the intrinsic valuation specific to your model.
+  - question: How do you calculate the terminal value in a DCF using the exit multiples method?
+    answer: The exit multiples method uses some standard financial multiple based on comps to determine what the value of the company is at that point in time. The exit multiples method is calculated with the formula Terminal value = Final Year EBITDA x Exit Multiple. EBIT, free cash flows, etc. can also be used in place of EBITDA. The exit multiples can come from comps, recent transactions, etc.
+  - question: How do you calculate the terminal value in a DCF using the growing perpetuity method?
+    answer: Use the formula Terminal Value = Discounted Cash Flow / (Discount Rate - Growth Rate). An alternative formula that can be used in the growing perpetuity method is Terminal Value =  Discounted Cash Flow x (1+ Growth Rate) / (Discount Rate - Growth Rate). The discount rate is your WACC or hurdle rate, and the growth rate is your expected growth rate past your forecast period. Typically, GDP growth rate or the risk free rate are used as the growth rate. The discounted cash flow is the DCF you have for the first year outside of your forecasted cash flows.
+  - question: What is the terminal value in a discounted cash flow (DCF) model?
+    answer: Typical DCF models will be anywhere from 3 to 10 years in length. Ideally, you will use assumptions and data to forecast these years in as much detail as possible. However, there comes a point when either you cannot realistically forecast detailed cash flows or the business you are modeling is forecasted to stabilize. At this point, it may still be the case that the business you are modeling will continue to generate cash flows indefinitely. In order to properly determine the value of any business or investment, you must account for these future years beyond your 3 to 10 year forecast period. This is where the terminal value comes in. It summarizes these future cash flows so you can include them in your model. There are two methods to calculate the terminal value. First, you can use the exit multiples method, which uses some financial multiple (e.g., EBITDA x 10) based on comps. This formula is Terminal Value = Final Year Finance Metric x Exit Multiple. Here, the finance metric can be EBIT, EBITDA, revenue, free cash flows, etc. Second, you can use the growing perpetuity method, which uses the intrinsic forecasted cash flows in your DCF. There are two acceptable formulas for this method (1) Terminal Value =  Discounted Cash Flow x (1+ Growth Rate) / (Discount Rate - Growth Rate) or (2) Terminal Value = Discounted Cash Flow / (Discount Rate - Growth Rate). Note that in both cases, you must used the discounted cash flow from that final year (alternatively, you can use final year free cash flow, but then you must discount that result to the present value).
+  - question: When should you use the exit multiples method or the growing perpetuity method for the terminal value in a discounted cash flow model?
+    answer: There is no exact answer. However, understanding the pros and cons of each will enable you to make the correct choice given your scenario. In the exit multiples method, you are using some finance multiple (e.g., EBITDA x multiple) based on comps and recent transactions. This method uses actual data to demonstrate what the business is worth at that particular point in time. If you want to know what you could theoretically sell the business for at that point in time or you do not think it will grow in perpetuity, this method may be helpful. The growing perpetuity method provides the main benefit of keeping the intrinsic valuation in your model, without introducing some outside relative value. This method may be seen as less precise, however, given it makes assumptions on growth in perpetuity.