56 Pages Posted: 4 Jan 2018 Last revised: 25 Apr 2019
Date Written: April 2019
This study provides evidence relevant for estimating and evaluating the terminal value term used in DCF valuation. Consistent with common practice, exit multiples based on EBITDA dominate those based on either net operating profit after tax (NOPAT) or net operating assets (NOA). However, both NOPAT and NOA provide incremental information about the terminal value beyond EBITDA. 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, consistent 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 median return on net operating assets (RNOA) over the business cycle dominates current RNOA as a proxy for steady-state profitability. In addition, industry RNOA dominates firm-specific RNOA, but it does not subsumes the information in firm-specific RNOA. 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.
Keywords: DCF; terminal value; EBITDA; valuation; exit multiples; continuing value multiples; price multiples; steady-state; profitability; growth; WACC; accounting conservatism
JEL Classification: G12, G17, G31, G32, M41
Suggested Citation: Suggested Citation