I always have had interesting conversations around the assumption and concept of terminal value (TV) in my valuation and financial modelling classes.
The above formula is an extension of the Gordon Growth Model - an economic model developed by Myron Gordon, a professor from the University of Toronto, a key assumption being that a company lasts forever.
Corporate life cycles and the secondary market
The ecosystem of companies and their life-cycles today are very different from 40-50 years ago. Nokia came and went in 7 years. BlackBerry (RIM) lasted for no more than two decades. GE is probably one of the more closely relevant examples of how a company lifecycle could run its course for a relatively longer time before being dismantled into three separate segments in 2021. But I think most companies today don't enjoy that kind of legacy.
Many corporate decisions are made using five and ten year plans. While founders may even have a longer term view of how they envision the business to be, these are mostly aspirational, some might even say fluffy. To make a call on a business over a 20-year horizon is almost unfathomable. Most human minds can't handle outcomes beyond a few decades, and as a result, economists try and simplify this scientifically, and in the process, disregard the cyclical nature of businesses - which is a practical consideration for most investors with a finite professional life. After all, the terminal value is only as tangible as the ability to monetise the underlying asset at the right time.
The perpetual growth model also ignores the effects from secondary markets - investors and individuals that are prone to speculating on a company's value, taking positions both on the stock and derivative instruments such as CFDs and options.
This opens up an alternative scenario: Instead of holding on to a share to perpetuity, there is a choice to flip their position for a quick profit, as long as the equity story continues to hold up. This makes both the use of market multiples and communicating the right narrative even more relevant.
The 2% perpetual growth rate
Besides, as we all know, casting the remaining cashflows into terminal value after the forecast period usually implies that you are basing 60-80% of the total firm value on the discount rate and the perpetual growth rate, which to me seems very paradoxical given that we spend a significant amount of time working out the company's revenue and free cash flows, only to chuck it into a mathematical black box.
Interestingly, the so-called 2% rate widely used in our perpetual growth models originated from New Zealand in 1989 when the reserve bank codified its monetary policy.
According to the then central bank chief, he said that this was “a chance remark" and that the figure was "plucked out of the air to influence the public’s expectations”. The US would later on reference and incorporate this into their policy goals to balance economic growth, wages and unemployment among other things. If you try and communicate this with someone sitting in China or parts of emerging Asia, no one would have a clue what you were talking about. Most people in Asia simply don't care about what long-term growth rate you use for arriving at the terminal value.
Don't get so caught up in economic and finance theories
We used get into hours of academic discussions over the WACC and terminal value during my earlier days in banking. Some of it was deemed as a test of your corporate finance knowledge. Other times it was because a valuation report required the loose ends to be tied in order to arrive at a fair value, or that we needed to demonstrate some form of credibility in the delivery of our report.
The reality is: In the M&A world, there is no such thing as a fair value. No correct answer for the WACC. There are only astute decision makers and those who are afraid to get caught on the wrong side of the outcome. Calculating the cost of capital or terminal growth rate with precision is only crucial either from a financial reporting point of view or only if you expect someone important to be challenging these assumptions specifically.
"What is then the right discount rate to use?" Perhaps the more appropriate question is: What kind of returns are you expecting? If you are evaluating a start-up, this could be anywhere north of 35%. For private equity firms, the rates could range between 15-25%. Institutional investors of public equities could expect 9-15% with zero tolerance for failure.
Simply put: The discount rate is mostly investor-driven - which if you think about it, very similar to the CAPM (Capital Asset Pricing Model), only that the CAPM assumes the investors to be fully diversified. Investors who use their own yardstick for the discount rate and can't get to the valuation they want, generally try to manipulate the cash flows or find ways to "create value" in order to establish a case for the investment.
Don't get so caught up with economic and valuation theories. They are only as important as much as you can use them in the real world. As the dynamics of the real world change, so must our understanding and application of finance.
Whenever I approached the close of my financial modelling course, I always did a simple roll-call to call for feedback from everyone in the class. This time, instead of recycling this common practice, I decided to try out a different approach by using Mentimeter and getting everyone to input three keywords on how they felt about the last two days, and this was the result:
A million followers can't be wrong.
One of the key aspects of financial modelling is being able to accurately project cash flows. This has consistently been a perennial question that comes up - "how do we do it?", "How do we know that the numbers are reliable?", and of course the occasional remark from the seasoned industry veteran: "the assumptions are too conservative, I think it should be much higher!"
Subject matter experts and experienced professionals who have been in the game for a long time play an influential role in terms of how we rely on an estimation of the future. In today's context - given the speed and digital pervasiveness of information - the loudest person in the room can also sometimes be easily misconstrued an industry thought leader.
“Facts can be so misleading, but rumors, true or false, are often revealing."
- Colonel Hans Landa [Inglorious Basterds]
Before we had the TV, email and newspaper, people relied on word-of-mouth as their primary source of information. Casual banter amongst households within proximity was how we passed the word around.
There was usually nothing lost in translation and no one usually questioned its legitimacy. That playground of information is so different today. Part of how we receive information today has evolved to include social media channels, such as Twitter and LinkedIn. We no longer need to hear information directly from the proverbial horse’s mouth. It is incredibly easy to be swayed by the opinions of the majority, albeit online or offline. After all a thought leader with a million followers can't be wrong right?
“Be wary of self-proclaimed and crowd-proclaimed experts. It’s less likely that experts will be mimetically chosen in the hard sciences (physics, math, chemistry) because people have to show their work. But it’s easy for someone to become an overnight expert on “productivity” merely because they got published in the right place. Scientism fools people because it is a mimetic game dressed up as science."
"The key is carefully curating our sources of knowledge so that we are able to get down to what is true regardless of how many other people want to believe it. And that means doing the work.”
Projecting cash flows is a work of art.
You would be almost be certainly wrong if you think that the ability to project cash flows requires hard core quantitative and technical skills. Valuation and financial modelling is really part art part science. In fact I would even go further to say that a large part of it is art, since the desired outcome is almost always based on creatively imagining what the future beholds.
The narrative, so to speak, is as important as the numbers. As Yuval Harari puts it in his book:
"A person who wishes to influence the decisions of governments, organizations, and companies must learn to speak in numbers. Experts do their best to translate every idea into numbers."
And so, the process of constructing a financial model tries to achieve this.
I often get asked if I could provide excel templates for a variety of sectors that people could use to just work off, punching in the inputs to generate the valuation output. Unfortunately, I don’t think it works that way.
The real value in any financial modelling exercise is not the result it produces, but the mental exercise that you have to go through in order to produce a functional three-statement spreadsheet of intricately connected moving parts.
This is probably the same parallel why people run marathons - not to get from point A to point B but more so the journey, the process of having gone through first hand and pain of completing 42.195km and that personal feeling of having achieved something at the finish line. That sensation means something different to everyone.
The financial model is a representation of what you think of the business and possibly how you see it evolving over time. In the hands of another person, the model assumptions and outputs might look very different.
As Warren Buffet once famously said:
"The forecasts may tell you a great deal about the forecaster but they tell you nothing about the future."
Whatever someone wants has value.
Going back to the narrative, the valuation exercise is always all about that magic number and the story behind that number.
It is easy to play around with numbers, crunch the numbers and as a lot of bankers say - massage the numbers. Numbers are freely available nowadays with the Internet and relatively cheap access to that information.
Stories on the other hand are a reflection of the CEO’s ambition and the company’s vision of the future. In the modern and evolving digital world, social media has increasingly found its role as a facilitator of information (both true and fake), and does an incredibly good job of amplifying stories.
Just look at GME.
The boring brick and mortar retailer was reportedly shuttering stores in 2019 and went into a semi-crisis when revenues plunged in 2020. Yet, its share price defied everything the numbers were saying, becoming a cultural sensation on social media.
If you looked at Lehman Brothers' balance sheet back in 2008 they actually had "one of the strongest capital and liquidity positions the Firm has ever had". But the story unfortunately went sideways, souring sentiments very quickly, resulting in its shocking collapse, disregarding whatever the fundamentals and numbers were showing.
Cryptocurrencies and NFTs are also classic examples of how story-telling has manifested in valuation.
There is almost no means of proving why a digital image of a monkey could be worth thousands of dollars. There is also no real use for a digital monkey, and therefore, no way of doing a meaningful DCF valuation.
NFTs are simply worth what they are because people say so and because people want it.
You can’t model sentiment and emotion in a spreadsheet. You also can't do an analysis of the cost-benefits on waging war for national security. Neither can you put a price tag on human relationships. The numbers simply won’t stack up.
"The concept of economic value is easy: whatever someone wants has value, regardless of the reason (if any), and its value is higher the more it is wanted and the less there is of it."
Storytelling for what it is, is a persuasion exercise to galvanise interest and to sell something - an idea, a product, a call to action. But it remains effective only to the extent others believe and identify with it. Any story becomes instantly more believable if there is sufficient information and that the anecdotal evidence provided is relatable by the other party - which explains also why investor targeting strategies are different for retail punters and large institutional buyers.
Without connecting the numbers to a story, projecting cash flows simply becomes an emotionless exercise of numbers.
At the most recent run of my LBO class, someone asked me this question,
"What is the difference doing a DCF using the WACC and a DCF in an LBO model?"
If we consider the same company in both cases i.e. the free cash flows (to firm), FCFF are the same, isn't the DCF like an LBO? In a typical DCF valuation, the weighted average cost of capital (WACC) is usually applied as the discount rate on FCFF. This discount rate comprises two main components - the cost of equity and the cost of debt.
Why does capital come with a cost?
Nothing is free in this world. The people who choose to fund your venture or your business are giving up something - more specifically, the option of being able to put their money elsewhere and getting more than what they had in the beginning.
Some common examples are: interest income earned from putting a cash deposit with a bank, government and corporate bonds, or even just buying a stock that pays dividends. By choosing to invest with you, these people are giving something up, and that lost opportunity comes at a price, which loosely translates to the cost of capital.
Every business is built and funded on either debt or equity. Conventional wisdom tells us that borrowing cash is cheaper than issuing equity because lenders typically get more security over the assets in the business and also priority in repayment from any cash flows generated. Because lenders do not partake in profit sharing of the business, they get no economical upside in the event the company becomes wildly profitable.
Equity holders (or shareholders) on the other hand, have a vested interest in the profits of the company, prorated to their share of capital contribution. They get paid only after the company's borrowings are repaid and therefore take on relatively more significant risk in their investment.
The optimal capital structure
Depending on the nature of the business and its underlying industry dynamics, each company has a "magic" number for debt and equity in order to get the lowest possible cost of financing. This allows them to maximize the business value. This magic number is the optimal capital structure.
In asset heavy industries whereby the companies have fairly resilient cash flows, the optimal capital structure will lean towards a greater proportion of debt - for example, in real estate, this refers to the core and core+ properties. For early stage enterprises, especially technology based startups, the optimal capital structure will consist of largely equity.
In reality, every company will have a different benchmark for what is optimal. A business which has a strong and proven track record of operations may have more debt in its capital structure because of its favourable credit rating and therefore access to cheaper debt, as contrasted to a younger and much less established firm.
We try to generalize an optimal cap structure across companies within the same sector because we expect the revenue dynamics and operating cash flow margins to be fairly similar.
Now, in a DCF model...
The discount rate represented by the WACC is a mix of debt and equity equivalent to the firm's target optimal capital structure. When we do a DCF based on the WACC, the resulting number yields the fair value of the business.
For the layman, fair value means: What the average or "marginal" investor should pay to acquire the business in order to get an appropriate risk-adjusted return had he/she had invested in all the public listed stocks in the target company's home market.
The risk/return-adjustment mechanism here is the beta, which is loosely speaking - calculated from - the correlation between the movement of similar companies' share prices against the broader market index. As we use the broader market index as the basis for justifying risk/returns, any minor deviation of a company's share price from this index is implied as "risk" (for more technical information on beta read this).
Because every investor has a different expectation on the equity returns (or the cost of equity), the output of a DCF using the WACC as the discount rate does not translate to how much an investor should offer to buy a company. The WACC gives you the fair value, but in reality, you can always choose to offer something higher or lower. Whether or not the seller agrees to the valuation is entirely up to negotiations and other qualitative factors influencing the target company.
All things being equal and agreeable...
Let's assume that the fair value is the offer price. The DCF on FCFF of the business results in the enterprise value ("EV") of the company. Loosely translated, this refers to the price of ALL operating assets in the company.
"Why don't we do the DCF on the FCFE (equity cash flows)?"
In theory, you can. But in the case of most buyouts, the incoming investor assumes responsibility for financing the deal i.e. they will assemble the best possible configuration of debt and equity to buy over the shares from the sellers, and repay / re-finance most or all of the legacy debt in the business.
If the buyers are creditworthy, they stand to increase the amount of borrowings obtainable from the banks, allowing the deal to be financed with the lower amount of equity capital.
In an LBO...
The incoming buyer (usually a PE fund) will test and push the limits of the cost of capital (the WACC) to achieve the highest return on equity possible. Discussions around the future cash flows of the business often result in lengthy negotiations between the buyer and lending banks. Some of these conversations entail iterative spreadsheet calculations that ideally would solve for the maximum amount of debt that will support the financing of the deal.
What the buyer is really trying to achieve here is to find the magic number for the debt that will allow for getting the HIGHEST equity return (or equity IRR). In most PE funds, this number is at least 20%, depending company and region.
The simple mechanics.
For example: If the returns for investing in this business is 10 percent, and assuming the investor doesn't borrow any cash to finance the deal, he/she would get a return of 10 percent. This 10 percent is also sometimes called the unlevered IRR. Unlevered means that the acquisition was purely financed with equity money and no bank borrowings were involved - obviously not a very wise and efficient use of money to the seasoned finance professional.
In order for the investor to achieve a higher return, he/she would try and minimize the amount of equity by looking for alternative sources of funds - such as debt. However, this would only make sense if the cost of debt is lower than 10 percent. Anything form of financing which costs more than 10 percent and the investor is better off using his/her own money.
Now, let's assume that approximately half of the total investment was funded with senior secured debt at a rate of 5 percent. The banks which are lending to the buyer at this stage not only have the first right to claim the assets in the event the business goes into distress, they also have priority over the cash flows generated by the company. The risk of this investment is relatively low as compared to pure equity, hence the 5 percent.
Based on the structure above, this would result in an equity return of 15 percent based on:
Unlevered IRR of 10% = (50% x 5%) + (50% x 15%)
Now, 15% may sound like a decent return but most PE funds are also subject to hurdle rates (typically in the ballpark of 8%), leaving them with only 7% after returning principal + hurdle to their LPs. Naturally, one way to overcome this is to try and get more cheap debt to minimize the equity outlay.
Because every financial institution is subject to their own credit risk matrix and lending exposures, the amount of "lend-able" senior secured debt (based on 5.0% interest rate) will be limited.
The hunt for more capital.
At this point, the PE fund tries to source for alternative sources of financing junior to the 5 percent debt. But this will come at a higher cost because the rights /security to assets and first priority to cash flows in the business have already been claimed by senior debt lenders. This alternative sources of financing would be subordinated. In order to entice this pool of subordinated lenders, the buyer has to make the cost of debt more attractive by increasing the interest rate.
For illustrative purposes, let's say this is going to cost 8 percent and the investor is able to syndicate 50% of it. The resulting calculations would give an additional uplift, bringing the equity IRR to 22 percent as compared to the original 15 percent.
15% return = (50% x 8%) + (50% x 22%)
You now get the idea...
Is 22 percent enough you say? Can we find additional sources of capital which are cheaper? This shouldn't be difficult.
But at this point, both the company cash flows and debt capital markets are going to be fully stretched, and it might be even more challenging to find a sufficient pool of investors who are willing to finance the deal at this level of risk. Some alternative sources of capital at this stage would come from either mezzanine investors or bridge loans.
Closing thoughts.
The mathematics outlined above has been done on an illustrative basis to demonstrate how 'cheaper' bank debt and alternative financing sources can allow an investor to maximize the equity IRR in an LBO. While this may look simple, the complexities lies in the following:
FCFF considerations. In engineering the returns above, we have totally ignored the potential volatility in free cash flows, which could significantly influence equity IRR. This is why stable and visible cash flows are important in any LBO deal.
Depth of liquidity. The pool of available capital shrinks dramatically as we move from senior debt to subordinated debt to quasi-equity financing. As such, the term sheet for alternative financing will start looking a lot like equity further down the debt waterfall.
Cultural factors. The size and structure of the debt package is also partly driven by how sophisticated and comfortable debt investors are with the company and the jurisdiction that it operates in, including other factors such as cash repatriation and withholding taxes. This could also explain why many online LBO structures and templates are usually based on transactions done in the US and Europe. While the loan and corporate bond markets are fairly vibrant in Asia, quasi-equity financing structures still lag those in more mature capital markets.