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How to Calculate a Terminal Value For a Stock

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

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The Way To Value A Business

When you're thinking about how to value a stock or business, there are really only two numbers you'd need to add up in order to determine if what you'd consider paying for such a business. The first is the amount of cash the business is going to pay you over time. That's simple enough to determine if you have an asset that produces a fixed amount of income, but it can be infinitely more challenging with a business that has earnings all over the place, or whose earnings don't yet exist, or whose earnings are rapidly growing. However, this gives you some idea about important things to consider with cash flows and earnings, and the decisions the managers are likely to make. You need to discount those cash flows back to what they're worth today, since a bird in the hand is worth two in the bush, and money today is worth more than money tomorrow, on average, thanks to our good friend inflation.

The second input you need to value a business is called a terminal value. That sounds fancy, but it's just a number that describes what you could sell whatever's left after it produced some cash for you, or an estimate of how much cash the business will produce into the far future. With DCF (Discounted Cash Flow) valuation methods, it's not reasonable to assume the business produces a rapidly growing amount of cash forever—trees don't grow to the sky—so we need a final number to add to the cash flows, in order to determine the total value of the business.

Two Categories

When categorizing types of businesses for valuation, ask yourself a simple question: how long is this business going to be able to generate this type of cash? If it's growing, at what point is the growth likely to slow down, and is it ever going to reverse? In other words, is there some point in the future that you can identify, where the business will no longer be able to make any money?

Answering this leads us to determine whether we should consider the totality of the business as a collection of assets to sell in a few years on the open market, or whether we could think of the business as a perpetual cash machine, or a going concern. Clearly, these are dramatically different methods for calculating a terminal value to add to the cash flows, and it's important to classify the business properly. If you're not sure, maybe this isn't the best type of business for you to invest in, but if you're still interested in buying, you can always use the most conservative of the two valuation methods, providing you with a more likely margin of safety, in case your other assumptions are wrong.

Price Multiples

A very popular and common method used in calculating a terminal value is simply to multiply the final year's cash flows times a number. This number is usually based on what the long term P/E ratio (or another price multiple) has been, or the multiple the industry normally puts on such a business. This is absolutely a quick-and-dirty, back-of-the-envelope approach to calculating the terminal value, and the speed and ease with which you can come up with which you can come up with this multiple can be tempting and appealing. It can even be useful under the right circumstances, but you do need to keep in mind that the price multiple has nothing to do with the intrinsic valuation of the business, but is instead an educated guess at the price something will sell for. It's not a bad idea to take a look at this number, but eagerly jumping on an optimistic price multiple can be a dangerous assumption to make, so be careful!

Liquidation Value

Using the liquidation value is generally the most conservative method for coming up with a terminal value, although you'd always want to see for yourself to be sure. The concept is very intuitive: what could you sell everything that's left over if the business were to stop producing cash? Think about a yard sale: you could sell property, plant, and equipment (find these on the balance sheet, along with other physical assets), and determine what you might be able to sell these for, and you'll have a good start. Don't just take a look at the numbers on the balance sheet, though; if you're interested in investing in a business, you'll want to dig a little deeper and identify where the book value comes from. Don't forget to add net cash (cash on the balance sheet minus debt). Finally, consider assets the company might have that aren't properly reflected, which Peter Lynch called hidden assets. Is the brand's name worth something on the open market? What about a system of delivery that makes the business unique? Is there some intellectual property that might not have been considered by Mr. Market just yet? Sometimes you can identify really cheap businesses just based on hidden assets, and you can dive in confidently with a strong margin of safety.

Going Concern

If a business is robust and healthy, and very likely to last well into the next generation, a going concern terminal value is probably the most appropriate method to use here. You'll calculate the estimated cash flows into the future, or use analysts' estimates (if you trust them!), and once you've added up a few years, you can multiply the final year by some sort of perpetual growth rate. While this does rely on an assumption, you can make the growth rate very conservative if you'd like. A good rule of thumb is that a perpetual growth rate can never be higher than the growth rate of the economy, since a business would eventually outgrow an entire nation's economy if that were true! Using a risk-free rate (such as what 10-year US treasuries offer today) is a great approach here, since it sets a good floor on how poorly the business is likely to do, but it's also a reasonable proxy for a long term growth rate. Take into consideration how large the TAM (Total Addressable Market) is for whatever the business is selling, too: you certainly don't want a terminal value that assumes the business is worth more than the entire industry combined! A small company in an enormous market would likely have more potential future runway than a large company in a small market; common sense should always prevail, and checking assumptions is incredibly important. Think about whether the company has a moat, or whether the growth rate might need to be reduced in order to compensate for the risk of another company eating your business's lunch.

Take Your Time

Once you've determined which terminal value to determine, you're one step closer to valuing the entire business, so you can figure out if a stock is undervalued enough to buy or not. People often focus on the other components of a business valuation strategy (discount rate and expected cash flow values), but they don't spend much time on what can often be the biggest factor, the big number at the end you're adding to all the others like it ain't no thang. Instead, spend ample time considering what the appropriate terminal value would be, and you'll be much, much better positioned to buy and sell stocks.

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