Created by David Moore, PhD
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How does an intrinsic valuation deal with the infinite horizon problem?
In a DCF we address the fact that the firm is assumed to continue in perpetuity by calculating a terminal value, i.e. an estimate of the value of the firm at the end of the forecast window. We have two standard ways of estimating a terminal value: 1) Perpetuity growth and 2) Exit multiple.
Under the first method we continue an intrinsic approach and simply calculate the present value of expected future cash flows assuming a stable growth rate in perpetuity and continue to discount using the appropriate discount rate (WACC if UCF). We employ a perpetuity growth formula of CF/(r-g) This approach requires an assumption of the stable growth rate that is usually bounded by the risk free rate and overall growth rate of the company (historically 2-5%) and that the growth rate does not exceed the risk estimate.
Under the second approach we deviate from the intrinsic philosophy of focusing on cash flows and essentially use a relative (or comps) valuation. It is common to use an EV/EBITDA as the exit multiple, where an industry (comp set) peer average is used in conjunction with the estimated operating metric, in this case EBITDA, from the terminal year of the forecast window. Under either approach it is important that the firm has reached stable growth at this point in its life cycle and the value that is estimated than needs to be discounted back, as it sits in the terminal year, to the valuation date.
There are two terminal value calculations. The first one is CF/(r-g) and the second one is EV/EBITDA times EBITDA. We estimate the inputs using our model. The first approach is called perpetuity growth and the second approach is called exit multiple. They are both good methods and can be used in an intrinsic valuation.
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