Terminal value is one component of determining the overall value of a given enterprise. Terminal value can be estimated in three ways: Liquidation values, exit multiples approach or stable growth model. Terminal value is calculated to project the value of an entity (security or firm) at a future date in time-taking into consideration future cash flow at a discounted rate for a several year period. The discounted cash flow (DCF) method is examined in detail in this essay as one of the most widely employed methods for calculating terminal value. The DCF method of valuation is used in conjunction with rates of stable growth within companies after periods of high growth. Terminal values can represent a large part of the valuation of a firm and can be calculated for individual assets of a business or the business as a whole. This essay also reviews the topic of business valuation as a broader topic and identifies why the determination of the value of a firm is important to different stakeholders. The impact of company life-cycle growth and Mergers and Acquisitions will also be examined in the valuation context.
Keywords Burn Rate (Cash Burn Rate); Corporate synergies; Discounted Cash flow; Future Benefits; Liquidation of Assets; Mergers & Acquisitions; Multiples; Perpetuity; Steady State (aka Stable Growth); Synergy; Target Company; Terminal Value; Time Value of Money; Weighted Average Cost of Capital (WACC)
The process of arriving at a business' value must include a detailed and comprehensive analysis that includes factors such as, past, present and future earnings and overall prospects of the company. Earnings figures offer tangible metrics with which to calculate a company's performance over time and thus contribute to assigning a value to a company. When considering additional criteria such as "overall company prospects" in business valuation, there is a much greater probability that different judgments will yield different assessments of business valuation. Business valuation can be determined using a number of methods, each with its own set of variables which result in a wide variance in determining business valuation. "The primary difference among the various valuation approaches is attributable to the method in which those benefits are estimated. Controversy exists among valuation practitioners and academics as to which methods are most appropriate, as evidenced by, among other things, the substantial amount of litigation and other legal proceedings surrounding valuation issues" (Jenkins, 2006).
Importance of Valuation
Valuation of a corporation or business is important in a number of contexts. Valuation may be used to determine how much a company is worth as a going concern (operating company). If a company is being acquired, it is also critical to determine the value at which the acquisition makes good financial sense. Another scenario might involve determining the value of a business that is facing financial distress. Determining value for a company is not easy, nor is it an exact science. Much of the process of valuation is judgment-based, and poor decisions can result in a poor investment or financing decisions. The purpose of valuation provides the overall framework for management to make informed decisions. Corporate managers might be faced with several different contexts for valuation including sale, liquidation, acquisition or bailout (Giddy, 2006).
A business's value can be determined using different valuation models and variables.
The three broad approaches to estimating value are (Jenkins, 2006):
- Asset-based- determines the value of collective assets.
- Income-based- estimates future income streams (DCF-discounted cash flow method).
- Market based- uses market multiples of assets and income.
It is not realistic to assume that a firm will always be in business; many firms do fail. In such a case, a company's assets would be appraised and liquidated. The price realized after payment of outstanding debt would reflect the valuation of the business.
Discounted Cash Flow
This essay focuses primarily on the use of discounted cash flow (DCF) as a means of business value. The DCF valuation method ultimately calculates a terminal value for a business and is based on future operating results. DCF is considered the preferred tool to value a business and assumes that the company will continue to operate in the future. Future benefits to owners of a business are widely accepted as the value in owning a company. In order to determine the future value (acquisition price) of a business, it is necessary to project what value stream will be available in the future. DCF is based on projected future operating results, rather than historical results (Valuation Methodologies, 2005).
Mergers and acquisitions have been prevalent in recent years as more corporations expand into global markets. Having a realistic idea of the value that a business merger or acquisition can provide has become imperative in competitive markets. Investors rely on business valuation to project the future benefits and terminal values that influence where their investment dollars will go. A business valuation of the target (acquired) firm is required as part of the acquisition process and can have a significant affect on purchase prices and financing decisions. This paper discusses the role of DFC methods in determining the value of a target firm as well as other factors that influence the value and acquisition.
There are three general methods for determining, or estimating, the value of a business. They are:
- Comparable market-based;
An asset-based valuation method requires the appraisal of a company's assets and liabilities to determine their value in the current market. The appraisal may be done at a discrete level (individual assets) or collectively. It is often necessary to employ a specialist with specific industry knowledge to assign value to assets. The value of the assets is assumed to come from future income. Assets can generate income through their potential use or from their liquidation value.
Comparable Market-based Valuation Method
There are two different market-based valuations that are commonly used to ascertain business value: The comparison of similar transactions and the comparison of similar public companies.
- Transactions The analysis of financial and operating data from other similar transactions can be applied to a target company to predict value. The comparison is based on historical data and compares companies in similar lines of business to establish a price for the target firm.
- Public Companies Method This method uses benchmarks from existing public companies to determine business value for firms that are comparable to the target firm. Firms in publicly traded markets can be benchmarked by stock prices and provide nearly "real-time" views of markets. This method requires that investors see targets and comparables as similar to gain investor confidence.
In each of the above comparable market-based value methods, premiums or discounts may be applied to the valuation to reflect strengths/growth opportunities or weaknesses/challenges of the given target.
- Income Approach Business valuation using an income method requires two things: A reasonable estimate of the expected future benefits and an appropriate discount rate. The appropriate discount rate allows for the conversion of the future income to present day value.
The most common methods of estimating value have traditionally involved the discounting or capitalizing of an income stream. In the income approach, variables such as earnings or cash flows are utilized as a proxy for the expected benefits to the owners of the business. Common examples of valuation methods under the income approach are the earnings capitalization model and the discounted cash flows (DCF) model (Valuation Methodologies, 2005).
In a capitalization model, a representative level of income is capitalized into perpetuity at a capitalization rate determined by the difference between the appropriate discount rate and a constant, sustainable level of growth (i.e., a price-to-earnings...
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