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## Terminal Values And Mid-Market Investors

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.

## SMEs And Net Income

I think it's safe to say when assessing a potential investment from a fundamental approach that most of us that using seeking alpha would look to a company's cash flow as an important if not the key gauge of its ability to generate profit. However, in many SMEs some management and surprisingly often the senior ones have a bad habit of looking at net income instead, and in the worst cases even use it as an investment metric. Notions such as this belongs firmly in the 1970's, along with disco and flammable suits. It can sometimes seem like this is the area of finance where accountants have thoroughly persuaded many SME managers into believing that net income is the same as profit. We could easily list a handful of reasons why net income does not equate to profit, but for now it's easier to just leave it to one side and say, in general the accruals and cost matching principal mean that net income is at its very best a proxy for profit. For the sake of keeping things moderately interesting, let's leave the issues of tax structuring aside, as important as they are, for another time.

Perhaps this is stating the obvious but, if a company is not making cash in the long run it's toast; financial history is littered with large companies that failed because of their lack of ability to generate cash. To continue as a going concern a company may survive for a while on net income but ultimately it needs cash. A key tool in understanding a company's investment potential is the understanding of how its operating cash flow is being made and not to get caught up in ratios and other metrics that focus on net income.

The accrual method permits management various options to record financial transactions; this can often leave a wide scope for earnings manipulation. It's only natural that if managers are remunerated based on a metric within their influence, they will be very tempted to record transactions in a way that enables them make a larger bonus. Hence when they are remunerated based on net income there is great incentive to overstate profit before tax. So just to help highlight some of the ways this can be done, here are some of the classic adjustments you might want to look out for:

• The depreciation method;

• Assumptions of the pension account;

• Assumptions of the exchange loss/gain;

• The reserves for bad debts;

• The methodologies and assumptions of inventory/investment valuations;

• The timing for the impairment of intangible assets

A good place to look to get the ball rolling is to check if a company's cash flow from operation is lower than its net income; this may mean that something is up with the cash conversation cycle, particularly so if this situation has gone on for some time. The cash cycle can give great insight into how well a business can convert inventory into cash, and how long cash gets locked up on the company's balance sheet for. This by no mean indicates cash from operation can't be manipulated, managers can still extend payables, reverse charges and employ many other tricks; but these are much harder to sustain in the long run than the low hanging fruit of net income manipulation. On a more conceptual note, for some complex organisations such as banks, diversified conglomerates and multinational corporations, the notion of net income can often have little meaning to non-accountants or those lacking the time or energy to read all of the various notes to the financial statements

## The IRR And Unsophisticated Investors

In mid market transitions you often come across inappropriate use of financial metrics, but none seems as prevalent as the Internal Rate of Return (NYSE:IRR). Despite a river of ink being spilt on the subject, it seems a sad fact that in many small and mid market transactions the IRR is still the preeminent metric in assessing projects. A lot of the inaccuracy can, if someone is determined to use it, be modified to represent a more reasonable figure. I refer to the Modified Internal Rate of Return (MIRR), while which not perfect, in practice, is normally more realistic and conservative than the IRR. Many of those that appraise investments regularly will already be familiar with the problematic issues relating to the IRR. However, for those of you that haven't yet wondered about the issues with this simple and elegant formula, then here's the problem (one of many I might add), it does not represent the real return on the investment, it merely represents the theoretical return an investor will get, assuming no risk in reinvesting those cash flow. Just to be clear, this is the discount rate at which the Net Present Value (NYSE:NPV) of the project would be zero, if that sounds a little convoluted let's look at an example to help highlight the issue. While IRR assumes the cash flow from a project could be reinvested at the same rate, the MIRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost.

The table below highlights the point in numbers, despite the two present value (PV) lines looking substantially different they are the same cash flows simply reinvested at different rates. One line shows the interim cash flow reinvested at the projects IRR of 10% and the other at the more realistic cost of capital. Just to be clear both lines have the same undiscounted cash flows, risk, and investment horizon and the same 10% IRR. If we use the IRR as our decision metric, we would not be aware of the substantial reinvestment risk. So in this case, an investment for $100m with the same exit value, over a 15 year duration (and a flat 10% free cash flow yield), we would end up with an immense $57m lower return then expected from the 10% IRR.

Years

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

Sum

Project cash flow

10

10

10

10

10

10

10

10

10

10

10

10

10

10

110

250

PV of the cash flows reinvested at the project IRR

28

25

21

19

16

14

11

9

8

6

5

3

2

1

0

168

PV of the cash flows reinvested at the cost of capital

18

16

14

12

11

9

8

7

5

4

3

2

2

1

0

111

In order to earn the stated return of a 10% IRR, the formula assumes that an investor can reinvest the interim cash flows through to the end of the investment horizon at a rate equal to that of the IRR. Even with the greater certainly of fixed income investments, this is practically impossible, and as a result, the investor would not earn the stated IRR on the investment.

Whenever the calculated IRR for a project is higher than the true reinvestment rate the investor can really achieve on the interim cash flows, the IRR formula will overestimate the return from the investment. This will pretty much always be the case for many of this type of investors that use IRR as their key metric. This is a more important issue for large corporations that tend to hold investments for a very long time and have low real reinvestment rate.

In practice, when the cost of capital (a proxy of the reinvestment return) is used instead of the IRR, a project's true IRR will fall considerably, this is particularly so with projects that forecast high IRRs, long durations or when the interim cash flows occur earlier in the investment horizon. If the executives making investment decisions are fully aware of these issues and/or can incredulously do the adjusting maths in their head then there's no problem. However, from experiences this is sadly not the case, and the discussions regarding project IRRs look as common as ever. Additionally none of the above takes account that the project cash flows also needs to be held for the duration of the project to achieve the IRR. If you are now wondering how to avoid the pitfalls of the IRR, then simply stop using it and use the NPV instead, which side steps this by simply discounting a projects cash flows at the cost of capital.