How to Pick the Terminal Multiple to Calculate Terminal Value in a DCF

You’ll learn how to select a Terminal Multiple for use in a DCF in this lesson.
This training includes how you can check the long-term Free Cash Flow growth rate implied by the Terminal Multiple, how to use data from the comparable public companies, and how to draw conclusions about your analysis with these formulas.

Table of Contents:

2:16 Why Most Sources Get This Explanation Wrong

6:33 How to Determine the Growth Rate Implied by a Terminal Multiple

14:46 How to Use the Implied Growth Rate in a DCF

17:09 Conclusions From This Analysis

20:03 Summary

Lesson Outline:

How Do You Pick the Terminal Multiple in a DCF?

Idea: For the Terminal Value, you need to estimate the company's value in the "far future" period… what are all those cash flows worth if you go past Year 5 here, or if you go past Year 10 in a 10-year model?

Two methods: the Multiples Method, where you assign an EBITDA multiple to the final year EBITDA, assume the company gets sold, and value it like that; or the Gordon Growth or Perpetual Growth or Long-Term Growth Method, where you assume it operates
indefinitely.

Need to make sure both methods make sense by themselves, and that the implied multiple and the implied growth rate from both methods seem reasonable.

The Multiples Method – Selecting a Multiple

You might START by getting the median EBITDA multiple or range of multiples from the set of public comps, and then applying them to this company’s appropriate figure in the final projection year… BUT…

You generally want to assume a discount over historical multiples, and even over forward multiples. Why?

1. Multiples generally decline over time as companies get bigger and growth slows down, so investors won't pay as much.

2. The "Terminal Multiple" must imply a reasonable Terminal Growth Rate… if you get something like a 10% FCF growth rate implied by your Multiple, you should be VERY suspicious - no company has ever grown at that rate for decades!

(Of course, this also depends on the discount rate - with a higher discount rate, higher growth might be justified.)

3. You also care more about the RANGE of Terminal Values and implied Enterprise Values from a RANGE of reasonable multiples (ex: 25th to 75th percentile of comps, modestly discounted).

How do you get the implied Terminal Growth Rate from a Terminal Multiple?

Implied Terminal Growth Rate = (Terminal Value * Discount Rate – Final Year FCF) / (Final Year FCF + Terminal Value)

Derivation: Please see the PowerPoint slides or PDF at the top. You start out with the familiar Terminal Value formula, Final Year FCF * (1 + Growth Rate) / (Discount Rate – Growth Rate), and then use algebra to get the Growth Rate on one side of the equation.

You have to go through a few steps to do this, but it’s fairly simple algebra.

How do you decide if this is an “appropriate” implied Growth Rate?

It should ideally be LESS than the GDP growth rate of the country this company is in, which means a very low percentage in most developed countries (e.g., less than 3% in the US) because all companies slow down to the rate of growth of the overall economy, or less, in the long-term.

You could also look at the expected long-term FCF growth rates of comparables, or the growth rates implied by their multiples. Some people also use other macroeconomic indicators like the inflation rate as a guideline.

Conclusions From This Analysis:

The baseline multiple of 5.9x we used isn't "wrong" necessarily, but we should probably project further into the future and create a 10-year DCF because the NPV of the Terminal Value comprises over 70% of the total implied value right now – it should ideally be ~50% or less.

We should also probably pick narrower ranges for these tables – 4.5x to 8.5x is too wide a range and may not even be meaningful.

And… the company was almost certainly overvalued at the time we did this analysis, since nearly all the values were below the current share price of $17.87.

We only get values above $17.87 if the assumptions are *very* optimistic, indicating that the company is overvalued or that our assumptions such as the discount rate are incorrect.

[rahulkewlani]

So Much Learning to do. Thanks a ton for the video. I'll be sure to go through more training of yours.
Thanks

[bigworm]

The big question from watching this is the assumption for long term growth rate at 16:00. My understanding is that when the exit multiple is used in the DCF it almost always as a exercise in pricing for an exit in the company or investment NOT as determination of intrinsic value of the business. In that case the long term growth rate will have much wider range than the LTGR proxy, US long term GDP growth rate.

[safeershahid]

Dear Great explanation. but i am unable to find the practice files/resources. please provide the link of the files. so i could practice along the tutorial.

[carlosmnic]

just got an offer also thanks to these videos. keep up the good work!

[tylerkatz]

These videos are great. I currently work in finance and these videos definitely help to strengthen the foundation for me. There are certain things that I have understood how to calculate, but never understood the intuition behind so thanks for creating the videos. Quick question though, what is the reasoning for saying that it's more preferable for ~50% or less of the value to come from the calculated terminal value? Is it simply due to the fact that the terminal value is a going concern basis, which makes it much harder to calculate accurately? So since the first five years of the projection involve a more in depth analysis, the discrete period can be viewed as a more accurate value? Thanks again.

[jamesfeldman]

Using an EBITDA multiple to calculate the terminal value effectively transforms a DCF into a relative (or "market-based") valuation. NYU's Professor Aswath Damodaran, and author of many first-rate valuation texts, such as "Damodaran on Valuation") has logically concluded that when an analyst is using an EBITDA multiple in a DCF valuation, the analyst is really doing a relative valuation. Since the terminal value is typically the largest component of the DCF model, the valuation is really a relative valuation "in drag, " as Professor Damodaran has put it, albeit one in the future. However, and as is suggested here in this video, even if an analyst insists on using such multiples in the terminal value calculation, to be intellectually honest, the analyst should still apply the genuine DCF inputs using the applicable cash flows and the cap rate and then compare the terminal value results as a sanity check, or back into the genuine DCF inputs to determine if the terminal value obtained from the relative valuation multiple used makes sense.

[alintapordei]

Hi Brian, thank you so much for the video. Is there any option to download the model? Thank you!

[marcuss]

I think one thing that isn't really discussed in selecting terminal value multiples, is which forward year multiples to pick, and why applying them to different year cash flows represent different valuations. eg. a current year sales multiple x year 10 sales gives the value at year 10, as will a one year forward multiple time year 11 sales. I have difficulty wrapping my head around this and if you could put up a video or something explaining this, that would be great.

[catherinecao]

Great information! I am currently building a DCF model, and I made a few improvements to my model after watching your videos. When I extend my projection from 5 year to 10 years, my terminal value remained the same without changing exit multiple assumption. This boosts EV. Is this intended, or should I adjust my edit multiple down when my yearly projection goes further out? Thanks!

[Bertztuful]

Hi Brian, great work on the video but I am a little confused

1) f we are determining the multiple based on the growth rate it implies, why do we even bother with the multiple ?

Why not Only use the perpetuity for TV ?
2)Also, as the company matures its Risk also decreases ? wouldn't that partially offset the impact of lower growth on multiple ?

[arnavvelaparthi]

Hi Brian, great video! Quick question about the multiples used when calculating TV - when we use forward looking multiples, we assume that the EBITDA grows and EV stays constant, which is why the multiple we use in the calculation of TV should have a slight discount. However, if we assume EBITDA grows year over year, technically shouldn't EV grow? Isn't cash flow generation growth an indication that the company is growing its enterprise value?

[wand]

Hi, very helpful series of video. I am confused between the changing use of FCF and EBITDA.

You have calculated Terminal Value as Last Year EBITDA x EBITDA multiple. Shouldn't last year FCF x FCF multiple be used to calculate TV instead for consistency?

For years 1-5, you have used FCF as a basis to calculate the sum of unlevered PV for those years therefore taking into account projections of capex, working capital and taxes. However, using EBITDA to calculate TV would exclude these projections and implicitly assume their amounts from the market multiple right?

[kln]

I see that you have discounted the terminal value using the multiple method. That is how I know it too but when you check Investopedia it says that it is not discounted ("How Is Terminal Value Discounted?"). Could you please explain?

Moreover, can you please explain whether a trailing or forward multiple should be used?

[yoelherman]

In the terminal value calculation (using the perpetuity method), you actually calculate the terminal value in year 6 actually because the numerator is the Year 6 FCF (Year 5 multiple by the (1+growth rate)), so shouldn't you discount it by (1+r)^6 instead of (1+r)^5?
If I'm wrong, it is not clear to me how in the bottom line you discount two figures (both the Year 5 FCF and the terminal value) with the (1+r)^5? it feels like it's double counting.

[mushtaqali]

If we choose a 7.5 x multiple, the implied Terminal FCF Growth Rate looks reasonable from the Company's and economic standpoint, however, the percentage of Implied EV from TV seems very high, in this case, 78.3%. Should we, in this case, extend our explicit forecast period to 10 or 15 years out? And what other levers do we have at our disposal apart from this to bring down the contribution of TV from Total Enterprise Value? Thanks.

[KrishanSingh-gzop]

I have seen some valuation videos where people use PE Ratio as terminal multiple to calculate terminal value. What's your view about that?

[markpenshorn]

Do your FCF calculations not consider inflation?  i.e. 3% growth doesn't seem too high when including inflation but would be a typical year (as mentioned) for GDP growth.  I wasn't sure whether this should be included when determining long term FCFs for future years.

[loadingnames]

just a quick question. the formula that you used to calculate terminal growth rate requires that you already have a terminal value calculated. if you already have the terminal value, which you calculated using the 5.9x, what is the point of finding the terminal growth rate? also, how do you determine what the baseline terminal growth rate? 

[prateekmehta]

A quick question, is there a excel template that we can download to practice what you have explained?

[fatemeazizi]

How do long-term growth rates affect DCF calculations?