Terminal Valuations - Theory and Practice

Yesterday, we had another Capital Markets Technical Prep session. We were looking at valuation methods including DCF, multiples, book value and precedent transactions.

In DCF, we talked about how to value a company's terminal value and discussed how in theory the values should be the same. This a concept I talked about at the Analyst Exchange when I was giving my lecture on geometric series (the math behind DCF's perpetuity formula). In the video, I briefly mentioned how our Hedge Fund Manager commented how it was a coincidence that the numbers were so similar. In theory, as our professor, Heather Ann Irwin mentioned, they should be the same and I just wanted to have a quick look at what the implication is.

There are two methods for valuing a companies terminal value are using a perpetuity method and EBITDA multiples.

The first method, the Terminal Value calculation using a perpetuity formula is: TV = FCF / (WACC - g).

The second method, the TV using EBITDA multiples is: TV = EBITDA x Multiple.

However, if in theory, they are supposed to be the same:

FCF / (WACC - g) = EBITDA x Multiple

I wanted to express the multiple in terms of the perpetuity formula so I rearranged the equation to get:

Multiple = (FCF/EBITDA) / (WACC - G)

This is exactly the point I was trying to make in my lecture in New York when I said that the two formulas and methods were related (except I forgot to highlight the "correction factor" between FCF and EBITDA which is essentially the same as a cash flow to operating profit margin - a factor which adjusts for the difference between FCF and EBITDA - just because EBITDA is often a proxy for FCF doesn't mean it's exact).

Another way of looking at this is as a mathematical proof for why comps valuation works. From an Integrative Thinking perspective, it is essentially looking at two different models for valuation which are looking at the same object and producing different results. Even though in theory both models look at the identical object, they will produce different values, yet I think this is a good integrative solution for understanding what is salient and causal in both models (and how they are related despite their differences).

In this way, if you could have perfect information, assuming that other analysts did comprehensive DCF, you could take a similar company and use the comps multiples to value that company.