Are Terminal Values Typically Too High, Too Low, Or Just Right?
Beyond the Tale of the Three Bears
Terminal values deserve substantial attention for the reason that that is where (most of) the value is found. Some approaches to terminal value tend to result in higher values, whereas other approaches tend to result in lower values. This article provides some insight into the implied assumptions and relative biases of these approaches.
Terminal values deserve substantial attention for the same reason Willie Sutton robbed banks—that is where (most of) the value is. Some approaches to terminal value tend to result in higher values, whereas other approaches tend to result in lower values. This article provides some insight into the implied assumptions and relative biases of these approaches.
Papa Bear Approach
Given that Papa Bear had the largest bowl of porridge, the Papa Bear approach refers to methods that arrive at relatively high terminal values. This discussion will highlight how a practitioner may arrive at a terminal value that is too high.
Exit Multiples
Perhaps the easiest way to overstate terminal value is to use an exit multiple based on current (i.e., as of the valuation date) multiples. For example, a practitioner may use a 10x EBITDA exit multiple because companies currently trade at 10x EBITDA. On the surface, this approach may appear objective because the terminal value is based on an observable input. However, there is an important implied assumption: growth prospects remain unchanged between the valuation date and terminal value date. That implied assumption is often (but not always) wrong because growth prospects tend to decline over time. Thus, the exit multiple should frequently be lower than the current multiple. Â Â Â
Gordon Growth with a “High” Long-Term Growth Rate
Another easy way to overstate terminal value is to dial up too much growth while using the Gordon Growth formula. The Gordon Growth formula (when properly applied) always arrives at the correct value given a set of assumptions.[1] The difficulty is determining the appropriate assumptions. Many practitioners will keep the base year cash flow constant and toggle the long-term growth rate (and discount rate).
The debate over how much long-term growth is too much can be interesting. Some will argue that the long-term growth must at least be equal to the expected inflation rate, whereas others will argue that may be too high due to the need to add more investments to the base year cash flow to justify that growth rate. Others will argue that some real (i.e., beyond inflation) growth should be included with the amount somewhere between zero and the expected real growth in the economy. Then there is the “two wrongs make a right” group, who cut the discrete period off too early (i.e., while it is still growing at rates above a steady state) and try to correct this mistake by including an additional component to the long-term growth rate. (This long-term growth rate is so high that it is like This is Spinal Tap’s turning of the speaker knob to eleven.) The determination re: whether a long-term growth rate is too high may be like Justice Potter Stewart’s definition of pornography: “I know it when I see it.”Â
Meghan Trainer: All About that Base
The base year cash flow is an important component of terminal values that can be overlooked. A terminal value is applied to the steady state (i.e., base) cash flow. It must follow that determining the appropriate base cash flow is key to arriving at a reliable terminal value.
It is not difficult to overstate the base cash flow. Assets with finite lives (e.g., net operating loss carryforwards) can be incorrectly included in the base. Businesses that coast on prior investments can generate temporarily high cash flows that are not indicative of the steady state. The discrete period projections can simply be too aggressive due to “plan to succeed” bias. One should be on the lookout for reasons why the base cash flow may be too high.
Baby Bear’s Approach
Given that Baby Bear had the smallest bowl of porridge, the Baby Bear approach refers to methods that arrive at relatively low terminal values. This discussion will highlight how a practitioner may arrive at a terminal value that is too low.
Circular Reasoning
A simple way to understate terminal value is to effectively assume that higher growth almost never results in meaningfully higher value. Some practitioners observe the folly of keeping the base year constant while togging the long-term growth rate assumption over an unreasonable range and highlight that there must be a link between investments and growth. While this is a reasonable perspective, it can go too far when it effectively takes a one-step forward, one-step back approach to valuation. This result occurs when the value of future growth is automatically assumed to be effectively offset by the value of future investments to fund the growth. (For example, a valuation that sets future investment requirements to the long-term growth rate divided by the WACC will generate small differences in value among a wide range of long-term growth rates.) This results in a scenario where the long-term growth rate assumption essentially becomes meaningless due to the circular assumption that value from future growth is almost completely offset by the cost of future investments.
There are two main reasons why this approach to terminal value may result in the values that are too low. First, the application may understate prior investments (and by extension future growth) because many long-term investments are expensed instead of capitalized in financial statements (e.g., research and development, and advertising). Second, there may be various intangible assets that support future growth which may not be readily apparent. For example, a successful professional service firm can command high current multiples that imply relatively high long-term growth rates while not investing a lot in areas such as marketing that may be viewed as necessary to support future growth in a “normal” company.
Meghan Trainer: All About that Base
It is also not difficult to understate the base cash flow. Businesses that are still growing above a steady state rate may be subject to a terminal value for convenience reasons (e.g., management did not project any further out into the future). Investment requirements may be overstated because they are based on higher levels of growth (e.g., working capital to support a business growing at four percent per year in the last year of the discrete projection period but the long-term growth rate is two percent per year). The discrete period projections may be too pessimistic due to hindsight bias, which can occur in a valuation as of an earlier date. One should also be on the lookout for reasons why the base cash flow may be too high.
Momma Bear’s Approach
Given that Momma Bear had the medium sized bowl of porridge, the Momma Bear approach refers to methods that arrive at medium terminal values. This discussion will highlight how a practitioner may arrive at a terminal value that is just right.
The first step is to get the base just right. The business must truly be at a steady state, which may not fit neatly with the goal of matching the discrete period to a set of management projections or to have a 5-year or 10-year discrete projection period. The discrete period must be extended if necessary, to reach the steady state.
The second step is to identify the appropriate long-term growth rate, which must be linked with the steady state cash flows. The long-term growth rate cannot be increased over a wide range in the search of a higher value. Similarly, the steady-state cash flows cannot be automatically lowered to effectively render the long-term growth rate assumption meaningless in situations when the assumption should be meaningful.
[1] It is easy to prove—just compare the terminal value using the Gordon Growth formula to a DCF using a discrete projection period that is several hundred years long.
Michael Vitti, CFA, joined Duff & Phelps in 2005. Mr. Vitti is a managing director in the Morristown, NJ office and is a member of the Disputes Consulting practice. He focuses on issues related to valuation and credit analyses across a variety of contested matters and industries. This article represents the views of the author and is not the official position of Duff & Phelps, LLC.
Mr. Vitti can be contacted at (973) 775-8250 or by e-mail to michael.vitti@duffandphelps.com.
