in these last few sessions we've talked about how best to estimate discount rates cash flows and growth in this session I want to focus on a fundamental point that we all have to remember when we do valuation all good things come to an end what are those good things if you have a high Growth Company it can't keep growing at those rates forever if have a company with great products those products might not stay great forever this session I want to talk about closure in valuation how we bring things together at the end and you have two choices at some point in time in your valuation you can assume that your business will end and that you will liquidate it sell it for what it can get on for the different assets the other is you can assume that the business will continue beyond that point in time it's called a going concern or a terminal value that number creates more mischief and valuation than any other input in this session I hope to put some rules in place that will keep that number from running away from you so we've talked about cash flows we've talked about discount rates we've talked about growth rates we have one final piece in this puzzle that we've got to get in place for valuation to work we have to put some closure on this process what I mean by that is you can't estimate cash flows forever right the value of an asset is the present value of its expected cash flows over time but what if you have an asset that potentially could last forever as is the case with a publicly traded company since you cannot estimate cash flows Forever at some point in time you've got to stop but you can't give up on cash flows either and what most people do is estimate what's called a terminal value so that's a role a terminal value plays it's that number that you're using as a bookend to capture what will happen Beyond year five or 10 or whichever year you put the terminal value in so what I'd like to do actually is talk a little bit about the approaches used to estimate terminal value and broadly speaking there are three approaches that are used to estimate terminal value in my view one of these three approaches should never be used but it's actually the predominant approach that ends up being used here's the first one at the end of year five year 10 year 15 you can shut the business down and sell off its assets that's called liquidation value when I value private businesses that is pretty much how I estimate terminal value almost all of the time because when the owner ends a business that's pretty much what happens to the business it gets sold off in pieces the second alternative is to assume a going concern value which is to assume your company will keep going after your five or 10 but that its cash flows will grow at a constant rate forever I saying what will that do for me if your cash flows grow at a concentrate forever you have what's called a growing perpetuity again you might wonder so what if you have a growing perpetuity you have an infinite series now this is becoming a mystery an infinite Series in mathematics we know the answer to we can actually solve the value of an infinite series that's pretty much what happens when you have a growing perpetuity you can write an equation that captures the present value of all cash flows beyond that point in time if you're willing to assume that your cash flows will grow at a constant rate forever that's a going concern value liquidation value and going concern value are both legitimate ways to get a terminal value so I've given away the game here's the one way you should never use to get a terminal value you shouldn't apply a multiple to your five or your 10 numbers an abidar multiple or a revenue multiple or an earnings multiple what's wrong with it if you do that you're really not doing intrinsic valuation you're doing relative valuation you're using a multiple your multiple is way out in the future but it's still a multiple people who use relative valuation to get the terminal value and claim to have done a discounted cash flow valuation are really presenting a rela evaluation in what I call drag those cash flows in years 1 2 3 4 and five are distracting they're distracting because they're distracting you from the key number used in the valuation which is the eight times Abid die used to get a terminal value so the next time you see a discounted cash flow valuation check out the terminal value if it comes from a multiple call it what it is it's a forward relative valuation so your choices are liquidation value or going concern value so the standard approach to estimating terminal value is that going concern approach we you assume your cash flows grow at a constant rate forever that's a very convenient way to estimate terminal value but it can also get you into trouble in fact when you look at valuations the number that usually gets valuations in trouble is the terminal value number so I'm going to introduce four very simple rules to keep your terminal value in check to keep it from running away with your valuation first check make sure that you don't exceed the cap what am I talking about remember in a going concern terminal value terminal valuation you assume your cash flows will grow at a constant rate forever that growth rate we said cannot exceed the growth rate of the economy but that leaves you with an estimation problem you don't know what that growth rate is going to be so here's a proxy you can use for the growth rate in the economy and as a cap on your terminal growth rate use the risk free rate think about what goes into risk free rate there's expected inflation and an expected real interest rate think about what goes into the growth rate of the economy expected inflation and an expected real growth rate I think the risk-free rate is an excellent proxy for the nominal growth rate in the economy but even if you don't think it's a good proxy I still think it makes sense to use it as your cap on your growth rate and here's why if you think the risk- free rate is too low your cost of capital is too low right to compensate then I'm going to force you to keep your growth rate low it keeps your valuations in sync so use the risk- free rate as the cap on your growth rate that's the first rule here's the second one you have to make a judgment about when your company will become a stable Growth Company my advice don't wait too long I've seen discounted cash flow valuations where people wait 20 25 30 years to put their company to stable growth that's extraordinarily long and here's why if you look across the history of U the US market and you look at growth companies about 99% of growth companies have growth periods less than 10 years in fact the median growth period for a high growth company is about 3 to 5 years I never use more than 10 years as as a growth period in my discounted cash flow valuation and if you're looking across companies trying to decide which company should grow for longer and which shouldn't grow for five maybe 6 8 10 years here are some of the things you should look at one is look at the size of your company relative to the market that it serves if you have a large company in a mature Market Toyota for example don't get carried away where's the growth going to come from use a shorter growth period if you have a small company in a huge Market Whole Foods and groceries for instance you have much more leeway you can allow for a longer growth period second look at recent growth not in earnings but in revenues Revenue growth rates give away the game before earnings growth rates catch on so your Revenue growth rate last year was only 5% be wary about using long growth periods and high Revenue growth rates and third remember it's not growth that creates value it's growth with excess Returns the stronger and more sustainable the competitive advantages your company has the longer its growth period can be so do some strategic analysis of your company third step in the process think about excess Returns what am I talking about I'm talking about the return on Capital you think your company will earn in perpetuity remember that return on capital is going to come under downward pressure from competition so one of the issues you have to examine in terminal values what kind of return on Capital you going to give your company and it's a big decision and here's the number you should compare it to you should compare it to your cost of capital in stable growth if you assume as some analysts do that in steady state stable growth you cannot maintain competitive advantages then The Logical assumption is the return on Capital should go to the cost of capital the excess return should go to zero if that is the case it doesn't matter what your growth rate is your terminal value will be the same whether you zero % growth 1% growth or 2% growth forever if you set your return on capital above your cost of capital and you might do that for some companies with really long-term competitive advantages then your growth rate will still matter but not as much as it would have if you hadn't brought the return on Capital down my rule of thumb with return on Capital and stable growth is for 80% of companies I go to the default the default is I set it equal to the cost of capital for one in five companies where I think that the competitive Vantage is are large and significant I will leave the return on capital above the cost of capital by maybe 2 or 3% that gives these companies an advantage and a higher value last piece when you make your company a stable Growth Company give it the characteristics of a stable Growth Company in other words if you have a bait of Two and a high cost of capital during your high growth phase that's okay but when your company becomes a stable Growth Company I would expect to see the beta move towards one maybe see it use more debt in its in its capital and a lower cost of capital your company cannot change in terms of growth with everything else remaining intact so in summary when you look at your terminal value make sure your growth rate is capped make sure you're putting your company into growth at a reasonable point in time make sure you're thinking about excess returns and perpetuity and make sure that you're giving the company the characteristics of a stable Growth Company if you do that your terminal value will stay within your control for