One of the most common mistakes your likely to come across in mid-market transactions is around the concept of Terminal Value, or TV. I'm fairly certain that many of the people reading a blog title like this one will already know the importance of the TV, and that it normally makes up a massive 50% to 80% of any given valuation. So given it's huge significance in how much we buy and sell investment for, it often comes as a surprise to many of us in the industry, how little understanding and confusion many market participants have with the concepts that underpin the TV. This, however, presents an opportunity when both selling and purchasing an asset, as when you look in the right places and in the right way, one can easily see faults in basic assumptions others have made.
While most of the time, many of us don't have time to think about the conceptual underpinnings of formulae and all of the detailed consequences of the assumptions we frequently plug into them, it can sometimes pay to take a deeper look. There are broadly two domains that errors tend to occur, one, is establishing the correct Free Cash Flow (NYSE:FCF) in the terminal year of a valuation, which can get quite dry and technical, so let's hold that whole kettle of fish back for another day. Instead I'm going to focus on the far simpler (and often more important in terms of its effects on value) category of checking the correct inputs for the TV itself. There are various ways a TV can be calculated. But by far the two most popular ways of addressing the TV are the Multiples method and the Perpetuity Growth Method. So before we get into the detail of how to turn this to your advantage, let's quickly recap on the main concepts that underline them.
First off is a particular favorite of the older generation and those that seek simplicity, is the Multiples Method, which most often takes the form of using a company's EBITDA in the terminal year of a valuation and multiply it by a certain amount. This should represent the value equal to the discounted forecast future cash flows of the company. This approach has the benefits of being very simple and can make it easy to compare a broad set of companies across an industry, but, it also has some disadvantages, such as:
· EBITDA neglects working capital requirements of a company.
· The valuation often hinges on the interpretations of others and tenuous extrapolation of market transactions by means of the multiple, and not the underlying drivers of value.
· The use of EBITDA multiples will involve finding comparable companies in the same and similar industries, which can often prove difficult in certain sectors.
· The metric doesn't account for prospective changes in cash flow and can overstate income,
· The metric is accounting based and very much depends on accounting adjustments made to reach EBITDA.
There's more but I think you get the gist of it by now. The bottom line is that EBITDA is not a real figure, it can often be a good proxy but it's only that, and should be kept in mind when using it in valuations. However, as we will see if someone has used this method it can offer an opportunity in the form of a mispriced valuation. In the case of a model using the Perpetuity Growth Method you can simply look to the inputs to see if the assumptions are reasonable or not, however, with a Multiple Method you can't gauge that information readily, to do so we can use a simple formula that I will come on to a little later.
Before that, let's briefly go over the Perpetuity Growth Method. With its grander sounding name, it promises a little more sophistication, and indeed it is viewed by many as the more reliable method. This technique anticipates the future value of a company, typically derived from the last forecasted year in a Discounted Cash Flow (DCF) valuation; that should represent the stable free cash of the company. Whereas the denominator acts to amplify the value of this cash flow as if it were to be received in perpetuity. This amount represents the value of the company assuming it's sold. Essentially there are only three components in the Perpetuity Growth formula; the FCF as the numerator, and the Weighted Average Cost of Capital (OTC:WACC) and the forecast growth rate as the denominator. So this method assumes that the company will continue its historic business and generate free cash flow in a steady state in perpetuity. The calculation is as follows: TV=(FCFn x (1-g))/(WACC-g)
Now, back to the humble formula that will help us spot a pricing error. Well if we've been given the anticipated value of the company from the Multiple Method, one can simply back out from the TV the implied perpetuity growth rate. To do this we will need the FCF in the last year, WACC and the TV. Using these we simply rearrange the Perpetuity Growth formula as follows: Implied g=(TV x WACC-FCFn)/(TV+FCFn).
After applying this formula you can then go about assessing if this number is credible. The resulting number will always be highly debatable and will depend on the countries that the company operates in, but if you're out of the 1.0% to 2.5% territory then you might want to take a closer look. First and foremost you have to remind yourself that this rate has to be sustained in perpetuity, i.e. forever! So regardless of what crazy talk you might hear from colleagues, advisors or anyone else, since a firm can't in the long run grow faster than the economy, its growth rate can never be bigger than that of the economy. This helps set a backstop to which you know you can't go higher than. Another pitfall to watch out for is a very common assumption that you can just use inflation, (often ~2%) as the long term growth rate. Again, if you just think about it for a moment, if you apply this to all your models and it turns out that every company does in fact grow with inflation; then by omission we are a dystopian bunch who predicts a world of zero growth. Which despite my often misanthropic view, it certainly doesn't seem right to anyone that holds apple stock or keen on Mr. T type artier when purchasing ETFs.
The above broadly gives us a range to work within, but what's the right rate? Well once again this can get a bit dry and technical. Textbooks will say to look at the historical growth or analysts' estimate in earnings per share to get a good base; however, this may not be available to mid-market companies etc. So when trying to gauge you may want to put things in a historic context and get a feel for the underlying drivers of value, you may want to look at ratios such as, (Cap Exp/Investment) - (Depreciation/Investment) or (Cap Exp/Depreciation) x (Depreciation) - (Depreciation). While the above might not tell you the exact right rate to accept or apply, the implied growth rate formula should help you get a head start on the less sophisticated investor. When you start to investigate you may well find entertain growth rates well into the high teens, or others errors that have arisen form the simple application of the ubiquitous 7x multiple.