The discounted cash flow valuation method is based on the capacity of the company in question to generate wealth in the future. To this end, the company's cash flows are projected and discounted at a rate accordingly.
One of the assumptions taken into account when estimating cash flows is that the company's activity will continue for an indefinite period of time. In other words, the so-called basic going concern principle.
In this way, these flows should be projected to infinity and then calculated at present value. As is evident, this approach lacks all practicality, so it is common to divide the life of the company into two periods:
Therefore, the terminal value reflects the future value of the cash flows expected by the company in the remainder of its infinite life, after the discrete period. Its calculation is based on the assumption that from year 'n+1' onwards the company's cash flows will continue to grow at a constant rate. Thus, the terminal value can be thought of as an annuity.
For all these reasons, it is essential to calculate it correctly, because as trivial as it may seem, it is just as important as any other cash flow.
There are 6 main errors when estimating terminal value. Below, we list them in order to be aware of them and avoid them in future valuations that may be carried out in the field of corporate finance:
Special attention must be paid to the cash flow pertaining to year 'n', since it is the cash flow on which the projections will be carried out towards infinity. Thus, if the aforementioned year is not representative due to special circumstances in that year, or if any of its items are unsustainable in the long term, the necessary adjustments must be made.
For example, consider a year where capital expenditures are less than the expected depreciation. This situation taken to infinity would lead to negative net fixed assets, which makes no sense whatsoever.
Therefore, it is important to analyze the cash flow in year 'n', and make any necessary adjustments so that it can be considered a reasonable, consistent and sustainable cash flow over the long term.
Logically, the geometric mean is a much more accurate and precise indicator than the arithmetic mean, especially for long periods of time and with large variations in the values being calculated. Therefore, it is more convenient to use the geometric mean in the calculation of the various concepts than to include it in the terminal value formula.
When calculating the residual value as an increasing perpetuity, the correct formula is as follows:
VTt = CFn+1 /(K – g)
The most common errors arise from using a cash flow pertaining to year 'n', or using the cash flow pertaining to year 'n+1' multiplied by the expected growth. The correct formula includes the future value of the annuity, i.e. the value of the annuity in year 'n+1'.
It is very common to make mistakes in the timeline of cash flows, anticipating or delaying some of them incorrectly. To avoid this mistake, it is very useful to draw a timeline with the different cash flows.
The growth rate should be used to estimate the terminal value, and not the reinvestment rate, since it does not represent the company's growth.
The assumption of constant growth towards infinity of the company requires the use of a commensurate rate, but without it being disproportionate, always bearing in mind that it is the rate we are assuming for an infinite number of years.
To this end, it will be necessary to take into account the competitors, the market situation, the company's future forecasts and, above all, common sense.