Calculating a Consistent Terminal Value in Multistage Valuation Models

Abstract

Valuation analysis based on the present value of future cash flows often requires a multistage valuation model which includes a terminal value.  An accurate calculation of the terminal value is very important, particularly if it represents a significant portion of the stock price.  A typical analysis would include a finite forecast of cash flows for a five to ten-year period followed by a terminal value that represents all the cash flows thereafter.  A common assumption is that the valuation cash flows beyond the finite horizon simply continue to grow at a lower long-term growth rate.  The analysis in this paper demonstrates that such an assumption is rarely appropriate except under very restrictive assumptions, if consistent accounting relationships are maintained.  Using dividends as the valuation cash flows in an example calculation, the dividend at the point that the growth rate declines is shown to increase by a step function rather than simply growing at a lower, mature growth rate.  The size of the step function increase is then shown to change when the values of various key value drivers in the analysis are also allowed to change.  Such value drivers include the EBIT margin, the asset intensity, and the relative level of debt. The step function increase in dividends can have a significant effect on the size of the terminal value and highlights the importance of maintaining consistent accounting relationships when forecasting future cash flows in a multistage valuation model.