Wednesday, November 30, 2016

Myth 5.5: The Terminal Value ate my DCF!

When you complete a discounted cash flow valuation of a company with a growth window and a terminal value at the end, it is natural to consider how much of your value today comes from your terminal value but it is easy to interpret this number incorrectly. First, there is a perception that if the terminal value is a high proportion of your value today, the DCF is inherently unreliable, perhaps a reflection of old value investing roots. Second, following up on the realization that a high percentage of your current value comes from your terminal value, you may start believing that the assumptions that you make about high growth therefore don't matter as much as the assumptions you make in your terminal valuation. Neither presumption is correct but they are deeply held!

If the terminal value is a high percent of value, your DCF is flawed!
To understand why the terminal value is such a high proportion of the current value, it is perhaps best to deconstruct a discounted cash flow valuation in the form of the return that you make from investing in the equity of a business. For simplicity, let’s assume that you are discounting cash flows to equity (dividends of free cash flow to equity) to arrive at a value of equity today:

Note that if you were to invest at the current value and hold through the end of your growth period, your returns will take the form of annual cash flows (yield) for the first five years and an expected price appreciation, captured as the difference between the terminal value and the value today. So what? Consider how investors have historically made money on stocks, decomposing US stock returns from 1928 through 2015 in the graph below:

1-Year Horizon5-Year Horizon10-year Horizon
Note that no matter what time period you use in your assessment, the bulk of your return has taken the form of price appreciation and not dividends. Consequently, you should not be surprised to see the bulk of your value in a DCF come from your terminal value. In fact, it is when it does not account for the bulk of the value that you should be wary of a DCF!

Determinants of Terminal Value Proportion
While the terminal value will be a high proportion of the current value for all companies, the proportion of value that is explained by the terminal value will vary across companies. When you buy a mature company, you will get larger and more positive cash flows up front, and not surprisingly, if you put a 5-year or a 10-year growth window, you will get a smaller percentage of your value today from the terminal value than for a growth company, which is likely to have low (or even negative0 cash flows in the early years (because of reinvestment needs) before you can collect your terminal value. This can be seen numerically in the table below, where I estimate the percentage of current equity value that is explained by the terminal equity value for a firm with a high growth period of 5 years, varying the expected growth over the next 5 years and the efficiency with which that growth is delivered (through the return on equity):

Excess Growth Rate (next 5 years)ROE = COE -2%ROE = COEROE = COE +2%
In fact, if the reinvestment needs are large enough or the company is not quite ready to make profits, you can get more than 100% of your value today  from the terminal value. While that sounds patently absurd, it reflects the reality that when your cash flows are negative in the early years (as a result of high growth and reinvestment), your equity holding may get diluted in those years as the company raises new equity (by issuing shares). Note that to the extent that the cash flows come in as anticipated, with high growth and low/negative cash flows, you will not have to wait until the terminal year to cash out, since the price adjustment will lead the cash flows turning positive. (You can download the spreadsheet and try your own numbers)

If your terminal value accounts for most of your value, your growth assumptions don’t matter
If you accept the premise that the terminal value, in any well-done DCF, will account for a big proportion of the current value of the firm and that proportion will get higher, as growth increases, it seems logical to conclude that you should spend most of your time in a DCF finessing your assumptions about terminal value and very little on the assumptions that you make during the high growth period. Not only is this a dangerous leap of logic, but it is also not true. To see why, let me take the simple example of a firm with after-tax operating income of $100 million in the most recent year, a five-year high growth period , after which earnings will grow at 2% a year forever, with a 8% cost of equity. Holding the terminal growth rate fixed, I varied the growth rate in the high growth period and the return on equity. The resulting terminal values are reported in the table below:

Excess Growth Rate (next 5 years)ROE = COE -2%ROE = COEROE = COE +2%
Note that assuming a much higher growth rate and return on equity in the first five years has a large impact on my terminal value, even though the terminal growth rate remains unchanged. This effect will get larger for high growth firms and for longer growth periods. The conclusion that I would draw is ironic: as the terminal value accounts for a larger and larger percent of my current value, I should be paying more attention to the assumptions I make about my high growth period, not less!

If you are valuing equity in a going concern with a long life, you should not be surprised to see the terminal value in your DCF account for a high percentage of value. Contrary to what some may tell you, this is not a flaw in your valuation but a reflection of how investors make money from equity investments, i.e., predominantly from capital gains or price appreciation. You should also be aware of the fact that even though the terminal value will be a high proportion of current value, you should still pay attention to your assumptions about cash flows and growth during your high growth period, since your terminal value will be determined largely by these assumptions.

YouTube Video

  1. Returns on US Stocks: Dividends and Capital Gains
  2. Spreadsheet to compute effect of growth assumptions on terminal value
DCF Myth Posts
  1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
  2. A DCF is an exercise in modeling & number crunching. 
  3. You cannot do a DCF when there is too much uncertainty.
  4. It's all about D in the DCF (Myths & 4.5)
  5. The Terminal Value: Elephant in the Room! (Myths & 5.5)
  6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
  7. A DCF cannot value brand name or other intangibles. 
  8. A DCF yields a conservative estimate of value. 
  9. If your DCF value changes significantly over time, there is something wrong with your valuation.
  10. A DCF is an academic exercise.


Anonymous said...

very detailed set of posts which leave me with the following questions:

1. Why is a ten year DCF forecast so common?
2. It is hard enough to project Revs, Op margins and reinvestment needs over a long period of time, but to guess at negative growth in a TV seems to be a bit much. Since one should have already scaled down growth, taken Beta to 1, it seems to me that either a no growth scenario in TV or growth capped at nom int rate is more sensible. Who knows what company will survive long term? Many have remained in business for extended periods of time, generating revenues in line with inflation, but positive cash flows and not likely to go out of business any time soon.
3. Once a company has reached its mature phase, the non working capital needs, from my observations, are nil and an examination of a great many industrial and non industrial names seems to highlight that cash flows for these names still increase, marginally, without increased non cash w/c needs and capex only = to depreciation. In a great many cases they are earning at or above their cost of capital.

Seems that the goal of any valuation is to see what you think a company is worth vs. the market price, so suggestions of guidelines for doing DCF analysis makes sense.
It might be helpful, if you could do a post on how to decompose the assumptions in the market price of a given publicly traded stock. An assessment of the reasonableness of that price can also guide investors with regard to buy or sell decisions. Thank you

Hemanth Manda said...

Great post as usual. However IMHO there are a number of situations where you need to be careful as to how you calculate your Terminal Value. Expecting a business to last for eternity (and generating positive cash flows all along) is a huge assumption and one should be realistic while making such a bold assumption. This is especially true off late with a number of companies and their business models getting disrupted. Some of the lofty valuations afforded to startups are based on the premise that they will somehow generate and sustain positive cash flows 5 or 10 yrs down the road is a misnomer ... more so given their expected life cycle spans ( I am lauding to Technology companies here).

Fung C.F. said...

"The Long-Term Growth Rate ate my Terminal Value!"

Prof would you talk a bit more about LT growth rate? I find too little attention putting on this topic, 1% point increase will substantially inflate the P/FCF multiple of the terminal value, hence the whole DCF value.

Comparing 2.5% LTg vs. 5.0% LTg (assuming 10% discount rate), it translates to 13.3x P/FCF vs. 20x P/FCF, 6.7 times FCF difference! But most people don't actually understand LTg.

Also, many people talked about factoring in 5% perpetual growth in terminal value, which is an almost impossible feat to achieve (maybe just for Coca-Cola). Imagine growing a company 5% perpetually, I think only an immortal Warren Buffett can do that.

I like to think that determine LT growth rate is THE most important ART in DCF valuation. Or am I the only one who think that way?

Aswath Damodaran said...

You may want to look at myth 5.3. The growth rate is not the most critical input in determining terminal value. It is the excess returns that you assume with it. So, assuming 2.5% instead of 1% should not have a large impact on your terminal value and may have no impact at all, if ROC is close to your cost of capital.

Fung C.F. said...

Thanks Prof, sorry I missed out that piece, another great one anyway, eye opening!

My conclusion after reading: So I guess it is now boiled down to the ART of determining the perpetual ROIC then, right?

But how? Any reliable long-term ROIC records of the longest surviving companies, like Coca-Cola, DuPont, Colgate-Palmolive, Macy's, etc.?