Terminal Value

Terminal value is one component of determining the overall value of a given enterprise. Terminal value can be estimated in three ways: Liquidation values, exit multiples approach or stable growth model. Terminal value is calculated to project the value of an entity (security or firm) at a future date in time-taking into consideration future cash flow at a discounted rate for a several year period. The discounted cash flow (DCF) method is examined in detail in this essay as one of the most widely employed methods for calculating terminal value. The DCF method of valuation is used in conjunction with rates of stable growth within companies after periods of high growth. Terminal values can represent a large part of the valuation of a firm and can be calculated for individual assets of a business or the business as a whole. This essay also reviews the topic of business valuation as a broader topic and identifies why the determination of the value of a firm is important to different stakeholders. The impact of company life-cycle growth and Mergers and Acquisitions will also be examined in the valuation context.

Keywords Burn Rate (Cash Burn Rate); Corporate synergies; Discounted Cash flow; Future Benefits; Liquidation of Assets; Mergers & Acquisitions; Multiples; Perpetuity; Steady State (aka Stable Growth); Synergy; Target Company; Terminal Value; Time Value of Money; Weighted Average Cost of Capital (WACC)

Overview

The process of arriving at a business' value must include a detailed and comprehensive analysis that includes factors such as, past, present and future earnings and overall prospects of the company. Earnings figures offer tangible metrics with which to calculate a company's performance over time and thus contribute to assigning a value to a company. When considering additional criteria such as "overall company prospects" in business valuation, there is a much greater probability that different judgments will yield different assessments of business valuation. Business valuation can be determined using a number of methods, each with its own set of variables which result in a wide variance in determining business valuation. "The primary difference among the various valuation approaches is attributable to the method in which those benefits are estimated. Controversy exists among valuation practitioners and academics as to which methods are most appropriate, as evidenced by, among other things, the substantial amount of litigation and other legal proceedings surrounding valuation issues" (Jenkins, 2006).

Importance of Valuation

Valuation of a corporation or business is important in a number of contexts. Valuation may be used to determine how much a company is worth as a going concern (operating company). If a company is being acquired, it is also critical to determine the value at which the acquisition makes good financial sense. Another scenario might involve determining the value of a business that is facing financial distress. Determining value for a company is not easy, nor is it an exact science. Much of the process of valuation is judgment-based, and poor decisions can result in a poor investment or financing decisions. The purpose of valuation provides the overall framework for management to make informed decisions. Corporate managers might be faced with several different contexts for valuation including sale, liquidation, acquisition or bailout (Giddy, 2006).

A business's value can be determined using different valuation models and variables.

The three broad approaches to estimating value are (Jenkins, 2006):

• Asset-based- determines the value of collective assets.
• Income-based- estimates future income streams (DCF-discounted cash flow method).
• Market based- uses market multiples of assets and income.

It is not realistic to assume that a firm will always be in business; many firms do fail. In such a case, a company's assets would be appraised and liquidated. The price realized after payment of outstanding debt would reflect the valuation of the business.

Discounted Cash Flow

This essay focuses primarily on the use of discounted cash flow (DCF) as a means of business value. The DCF valuation method ultimately calculates a terminal value for a business and is based on future operating results. DCF is considered the preferred tool to value a business and assumes that the company will continue to operate in the future. Future benefits to owners of a business are widely accepted as the value in owning a company. In order to determine the future value (acquisition price) of a business, it is necessary to project what value stream will be available in the future. DCF is based on projected future operating results, rather than historical results (Valuation Methodologies, 2005).

Mergers and acquisitions have been prevalent in recent years as more corporations expand into global markets. Having a realistic idea of the value that a business merger or acquisition can provide has become imperative in competitive markets. Investors rely on business valuation to project the future benefits and terminal values that influence where their investment dollars will go. A business valuation of the target (acquired) firm is required as part of the acquisition process and can have a significant affect on purchase prices and financing decisions. This paper discusses the role of DFC methods in determining the value of a target firm as well as other factors that influence the value and acquisition.

Applications

There are three general methods for determining, or estimating, the value of a business. They are:

• Asset-based;
• Comparable market-based;
• Income-based.

Asset-based Approach

An asset-based valuation method requires the appraisal of a company's assets and liabilities to determine their value in the current market. The appraisal may be done at a discrete level (individual assets) or collectively. It is often necessary to employ a specialist with specific industry knowledge to assign value to assets. The value of the assets is assumed to come from future income. Assets can generate income through their potential use or from their liquidation value.

Comparable Market-based Valuation Method

There are two different market-based valuations that are commonly used to ascertain business value: The comparison of similar transactions and the comparison of similar public companies.

• Transactions The analysis of financial and operating data from other similar transactions can be applied to a target company to predict value. The comparison is based on historical data and compares companies in similar lines of business to establish a price for the target firm.
• Public Companies Method This method uses benchmarks from existing public companies to determine business value for firms that are comparable to the target firm. Firms in publicly traded markets can be benchmarked by stock prices and provide nearly "real-time" views of markets. This method requires that investors see targets and comparables as similar to gain investor confidence.

In each of the above comparable market-based value methods, premiums or discounts may be applied to the valuation to reflect strengths/growth opportunities or weaknesses/challenges of the given target.

• Income Approach Business valuation using an income method requires two things: A reasonable estimate of the expected future benefits and an appropriate discount rate. The appropriate discount rate allows for the conversion of the future income to present day value.

The most common methods of estimating value have traditionally involved the discounting or capitalizing of an income stream. In the income approach, variables such as earnings or cash flows are utilized as a proxy for the expected benefits to the owners of the business. Common examples of valuation methods under the income approach are the earnings capitalization model and the discounted cash flows (DCF) model (Valuation Methodologies, 2005).

Capitalization Models

In a capitalization model, a representative level of income is capitalized into perpetuity at a capitalization rate determined by the difference between the appropriate discount rate and a constant, sustainable level of growth (i.e., a price-to-earnings multiple). The primary difference between discounting and capitalizing is the level of discretion afforded in controlling the growth of the income stream. In any case, reasonable growth assumptions and an appropriate discount rate are imperative for effective valuation.

In a discounting model, a projection of income is estimated for a finite period, followed by a terminal value calculation that assumes a constant income growth rate from that point into perpetuity (Valuation Methodologies, 2005).

Discounted Cash Flow Method

Discounted cash flow methodology is the preferred method for business valuation. This method is also a good one to employ when considering straight investment opportunities. It is important to remember that the goal of DCF valuation is to compute the present day value of cash flow over the life of a company. Put another way, this valuation is a way to project in terms of today's dollars, what a company will be worth in the future (5-10 years out). The analysis is broken into the two distinct parts that have already been discussed in this essay:

• Determine a forecast period (5-10 years) and predict free cash flow for that interval of time. Forecast periods may vary, but generally speaking, the forecast period will equate to the period of time that a firm can expect to enjoy competitive advantage. After the forecast period (x # of years), it is expected that the company will enter a period of stable growth-also known as a "steady state."

• The terminal value of the firm is calculated after the forecast period and once it is assumed that the company is in a steady state. A terminal value is captured at that point and WACC (weighted average cost of capital) is used to discount the terminal value into present value (value of company it today's dollars).

Stable GrowthAs a firm grows, it becomes more difficult for it to maintain high growth and it eventually will grow at a rate less than or equal to the growth rate of the economy in which it operates. This growth rate, labeled stable growth, can be sustained in perpetuity, allowing us to estimate the value of all cash flows beyond that point as a terminal value for a going concern (Damodaran, 2002).

Determining how and when a company might transition to stable growth directly impacts terminal value. A stable growth rate can occur in two general ways. The growth rate of a company will drop abruptly and equalize at a stable rate or growth will diminish over time and stabilize.

Factors that will impact a firm's transition to stable growth are:

• Firm size (relative to the market it serves);
• Current growth rate;
• Competitive advantage.

Issues

Life Cycle & Firm Survival

Companies that have achieved stable growth tend to be more mature firms that have been around for a while. A company that has achieved stable growth may or may not have been in a high growth cycle at some time in its existence. In today's marketplace, there are many firms that enjoy an almost meteoric rise in certain markets. As was emphasized earlier in this essay, rates of high growth are not sustainable indefinitely and companies tend to mature into a stable rate of growth.

"There is a link between where a firm is in the life cycle and survival. Young firms with negative earnings and cash flows can run into serious cash flow problems and end up being acquired by firms with more resources at bargain basement prices. Why are new technology firms more exposed to this problem? The negative cash flows from operations, when combined with significant reinvestment needs, can result in rapid depletion of cash reserves. A widely used measure of the potential for a cash flow problem for firms with negative earnings is the cash-burn ratio, which is estimated as the cash balance of the firm divided by its earnings before interest, taxes and depreciation- known as (EBITDA) (Damodaran, 2002).

Merger & Acquisition or Investment Valuation Methodologies

Companies that are targets of M&A are very often firms that are projected to have a period of high growth. In other cases, acquisition targets are seen as being very complementary to the acquiring firm. In any case, a number of high profile mergers and acquisitions have been documented; the following discussion centers on business valuation within the M&A context.

Of particular note in the M&A scenario are variables to valuing a company that can't be calculated directly or that are subjective and therefore alter valuation results. In the case of a merger, there are always at least two parties involved in the transaction; sometimes more. The first participant is the acquirer (bidder or buyer) and the second is the target firm (seller or acquired). One of the most fundamental questions for any acquirer is the following: Would the target company be a good investment? As with general business valuations and associated analysis, there are a number of questions that, once answered, can help with the valuation of a target company.

Non-Financial Variables for Valuation

The following are number non-financial statement variables that must be taken into consideration when completing a business valuation regardless of the valuation method used.

• There is proprietary technology in the target company. The target has a particular skill or expertise.
• There is a strong market position for the target company.
• The target company has an extensive sales network that will insure future revenue.
• There's an experienced management team at the target company and many will remain at target.
• There are cost savings to be gained from the merger.
• Synergies between the two merging firms will result in gains in operational efficiency.

Weighted Average Cost of Capital (WACC)

Another factor to be considered in an M&A situation is the nature of the relationship between the acquirer and target. If the target company is not in the same industry as the acquirer, then it can be assumed that the target will operate autonomously or as a stand-alone enterprise. In such an instance, the weighted average cost of capital (WACC) of the target company should be used when determining the discount rate for the firm's projected and terminal value. In a case where the target company is to operate autonomously, the risk to the investor is based solely on the risk associated with the target's cash flow.

In many cases, the M&A transaction was based on the potential "synergies" that would occur as a result of a merger. Synergies generally assume that the acquirer and target company are in the same industry and will combine the cash flows of the two organizations. Strategic acquisitions can alter cash flow considerably, and depending upon the perceived value of this variable and others, a "value" placed on potential synergies can have a pronounced affect on the final bid (or premium paid) for a company. Synergies are often a major consideration in negotiations regarding M&A deals. Analysts must take into consideration which WACC (acquirer's or target's) is appropriate for use in discounting combined cash flows. More variables are introduced at this point in the analysis, including risks to cash future cash flow and consideration of the financial structure of the post-merger firm.

In general, if a merger has occurred between two similar industries, the WACC of the acquirer can be used with the assumption that the business risk is similar for both firms. If the target company and acquirer are in different industries, the business risks are inherently different and unique; as are the assets, collateral and debt-paying abilities of each firm. As a rule of thumb, the business and financial risk of a firm should reflect the business of the target company if it is in a different industry than the acquiring firm.

Benefits of the DCF Valuation Method

The following points underscore some of the benefits of using the DCF valuation method (Chaplinsky, 2000):

• Not tied to historical accounting values. Is forward-looking- to future revenue.
• Focuses on cash flow, not profits. Reflects non-cash charges and investment inflows and outflows.
• Separates the investment and financing effects into discrete variables.
• Recognizes the time value of money.
• Allows private information or special insights to be incorporated explicitly.
• Allows expected operating strategy to be incorporated explicitly.
• Embodies the operating costs and benefits of intangible assets.

Conclusion

This paper outlines several different valuation methods that might be used to determine business value. It is generally acknowledged that no valuation method is absolute. "Every number in valuation is measured with error because of flawed methods to describe the past or because of uncertainty about the future" (Chaplinsky, 2000). Different valuation methods may be used for different components of a business and it may be easier to value a division or a product line than an entire company. Another way to use valuation methods is to use different scenarios to test differing results.

It is true that a large portion of the value of any stock or equity in a business comes from the terminal value, but it would be surprising if it were not so. When you buy a stock or invest in the equity of a business, consider how you get your returns. Assuming that your investment is a good investment, the bulk of the returns come not while you hold the equity (from dividends or other cash flows) but when you sell it (from price appreciation). The terminal value is designed to capture the latter. Consequently, the greater the growth potential in a business, the higher the proportion of the value that comes from the terminal value will be (Damodaran, 2002).

Terms & Concepts

Burn Rate (Cash Burn Rate): For a company with negative cash flow, the rate of that negative cash flow, usually per month. Often used by venture capitalists to measure how much time a startup has to reach positive cash flow.

Discounted Cash Flows: A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Multiples: A valuation theory based on the idea that similar assets sell at similar prices. This assumes that a ratio comparing value to some firm-specific variable (operating margins, cash flow, etc.) is the same across similar firms.

Perpetuity: An annuity that has no definite end, or a stream of cash payments that continues forever. Perpetuities are one of the time value of money methods for valuing financial assets.

Steady State (aka Stable Growth): As a firm grows, it will be difficult for it to sustain high growth. Eeventually, the firm will grow at a rate less than or equal to the growth rate of the economy in which it operates.

Synergy: Corporate synergy refers to a financial benefit that a corporation expects to realize when it merges with or acquires another corporation. This type of synergy is a nearly ubiquitous feature of a corporate acquisition and is a negotiating point between the buyer and seller that impacts the final price both parties agree to.

Target Company: A company that is being considered for acquisition.

Terminal Value: In finance, the terminal value of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period.

Time Value of Money: The idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value."

Weighted Average Cost of Capital (WACC): Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

Bibliography

Chaplinsky, S. (2000). Methods of valuation for mergers and acquisitions. Darden Business Publishing. University of Virginia. Retrieved September 20, 2007, from http://www.darden.edu/casecomp/pdf/F-1274.pdf

Damodaran, A. (2002). Closure in valuation: Estimating terminal value. New York University. Retrieved September 18, 2007, from http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch12.pdf

Jenkins, D. (2006). The benefits of hybrid valuation models. CPA Journal, 76, 48-50. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19365490&site=ehost-live

Giddy, I. (2006). Methods of corporate valuation. Resources in Finance. Retrieved September 20, 2007, from http://pages.stern.nyu.edu/~igiddy/valuationmethods.htm

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Meitner, M. (2013). Multi-period asset lifetimes and accounting-based equity valuation: take care with constant-growth terminal value models!. Abacus, 49, 340-366. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90467019&site=ehost-live

Platt, H., Platt, M., & Demirkan, S. (2011). Explaining Stock Price Volatility with Terminal Value Estimates. Journal Of Private Equity, 15, 16-25. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=67712913&site=ehost-live

Valuation methodologies. (2005). Met Advisors, Inc. Retrieved September 22, 2007, from http://www.metadvisorsinc.com/Valuation%20Methodologies.pdf

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Yin, C., & Wen, Y. (2013). Optimal dividend problem with a terminal value for spectrally positive Lévy processes. Insurance: Mathematics & Economics, 53, 769-773. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=92500538&site=ehost-live

Suggested Reading

Courteau, L., Kao, J., & Richardson, G. (2001). Equity valuation employing the ideal versus ad hoc terminal value expressions. Contemporary Accounting Research, 18, 625-661. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6049893&site=ehost-live

DeAngelo, L. (1990). Equity valuation and corporate control. Accounting Review, 65, 93-112. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9603274030&site=ehost-live

Penman, S. (2006). Handling valuation models. Journal of Applied Corporate Finance, 18, 48-55. Retrieved September 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21194447&site=ehost-live