Lecture Notes on Valuation and Terminal Value

Introduction

• Discussion about quizzes: available for pickup, can impact grades (10% weight).
• Terminal value is the biggest number in valuation.
• Importance of avoiding errors in terminal value calculations.

Terminal Value

• Terminal value provides closure to cash flow estimations.
• It can dominate valuation if not handled properly.
• Different methods to calculate terminal value:
  • Liquidation value
  • Stable growth model
  • Growing annuity
  • Avoid using multiples (common but misleading)

Growth and Efficiency

• Sustainable growth is linked to reinvestment and returns.
• Cisco’s example: high growth rate but eventually returns diminished.
• Growth quality varies by reinvestment and return on capital.
• Importance of unit economics and economies of scale in determining margins.

Revenue Growth and Market Share

• Understand the total market and share your company will capture.
• Competition and brand value influence growth potential.
• High growth potential in large, underserved markets.

Margins and Profitability

• Profit margins depend on unit economics and economies of scale.
• Competition and market dynamics can affect achievable margins.
• Importance of assessing management’s focus on profitability.

Reinvestment and Sales to Capital Ratio

• Reinvestment needs vary based on business model and industry.
• Higher sales to capital ratios indicate efficient growth.
• Consider lag between investment and revenue (e.g., pharmaceuticals).

Valuation Models

• Intrinsic value versus pricing approaches.
• Guardrails for using the Perpetual growth model:
  • Cash flow in the next period is critical.
  • Growth rate should not exceed economic growth rate.
  • Consistency in currency and cash flow terms (real vs. nominal).

Risks and Assumptions

• Be wary of using risk-free rates that are too low or high.
• Real interest rates should align with real growth rates.

Special Cases and Exceptions

• Mature companies and assumptions on reinvestment and growth.
• Adjust cost of capital and return on capital for mature firms.

Conclusion

• Various valuation models are essentially variations on how cash flows, discount rates, and growth are combined.
• Encourage using consistent frameworks and recognizing market dynamics in valuation processes.