Key Points from the Lecture on Valuation and Terminal Value

Introduction

• Recap of previous sessions: estimating discount rates, cash flows, and growth.
• Fundamental concept: all good things, such as high growth or great products, come to an end.
• Focus of the session: closure in valuation.

Two Choices in Valuation

1. Liquidation Value: Assume the business will end and sell for its asset value.
2. Going Concern Value (Terminal Value): Assume the business will continue operating beyond a certain time.
   • Terminal value often causes valuation challenges.

Importance of Closure in Valuation

• Cash flows cannot be estimated indefinitely.
• Terminal value serves as a bookend to capture future cash flows beyond a certain period (e.g., year 5 or 10).

Approaches to Estimate Terminal Value

1. Liquidation Value: Selling off business assets post-closure.
   • Common method for private business valuation.
2. Going Concern Value: Assuming constant cash flow growth forever.
   • Creates a growing perpetuity and can be mathematically solved.
3. Avoid Using Multiples:
   • Do NOT apply EBITDA, revenue, or earnings multiples to calculate terminal value.
   • Doing so leads to relative valuation rather than intrinsic valuation.
   • Using multiples can mislead the valuation process.

Standard Approach for Terminal Value

• Typically, the going concern approach is favored, where cash flows are assumed to grow at a constant rate indefinitely.

Rules to Keep Terminal Value in Check

1. Cap the Growth Rate:
   • The growth rate should NOT exceed the growth rate of the economy.
   • Use the risk-free rate as a cap; it reflects expected inflation and real growth rates.
2. Timing of Stable Growth:
   • Do not wait too long to transition to stable growth (suggested max of 10 years).
   • Historical data: 99% of growth companies have growth periods less than 10 years, with a median of 3 to 5 years.
   • Consider company size and market maturity when determining growth periods.
3. Excess Returns Consideration:
   • Assess the return on capital during stable growth.
   • Return on capital should be compared to the cost of capital; if competitive advantages are weak, return on capital should equal cost of capital.
4. Characteristics of a Stable Growth Company:
   • As the company transitions to stable growth, expect changes in beta towards 1 and an increase in debt.
   • Ensure growth assumptions reflect the company's transitioning characteristics.

Summary

• Ensure terminal value remains controlled by:
  • Capping growth rates appropriately.
  • Timing the transition to stable growth realistically.
  • Considering excess returns and ensuring that the characteristics of stable growth are met in valuations.