70 Pages Posted: 4 Jan 2018
Date Written: December 31, 2017
This study provides evidence relevant for estimating and evaluating the terminal value term used in DCF valuation. Consistent with common practice, EBITDA based exit multiples dominate those based on net operating profit after tax (NOPAT; essentially EBIT×[1-t]) or net operating assets (NOA; approximately equal to invested capital). However, both NOPAT and, especially, NOA provide incremental information about the terminal value beyond EBITDA. In fact, a simple average of the three estimates yields a considerably more accurate terminal value estimate than the EBITDA based estimate. These results demonstrate the importance of considering balance sheet information when estimating or evaluating the terminal value. The study also shows that through-the-cycle multiples dominate current multiples in estimating terminal value. This finding indicates that the benefit from using average pricing over the cycle, consist with the long-term average nature of the forecasted fundamentals to which exit multiples are applied, is greater than the cost of ignoring the permanent nature of some changes in exit multiples (e.g., due to secular changes in interest rates). Shifting to the determinants of the terminal value, the study shows that average return on net operating assets (RNOA) over the business cycle dominates current RNOA as a proxy for steady-state profitability. This result holds both for firm-specific and industry measures of RNOA. In addition, industry RNOA dominates firm-specific RNOA, but it does not subsumes the information in firm-specific RNOA. Still, improving on through-the-cycle industry RNOA is more difficult than simply averaging the different measures. The study also presents a framework for deriving a forward looking estimate of steady-state RNOA based on WACC and the estimated effects of accounting conservatism, and it describes alternative approaches for estimating steady-state growth and explains how this input is related to other determinants of the terminal value.
Keywords: DCF, Terminal Value, EBITDA, Valuation, Exit Multiples, Price Multiples, Steady-State, Profitability, Growth, WACC, Accounting Conservatism
JEL Classification: G12, G17, G31, G32, M41
Suggested Citation: Suggested Citation