Terminal Value (finance) - Comparison of Methodologies

Comparison of Methodologies

There are several important differences between the two approaches.

The Perpetuity Growth Model has several inherent characteristics that make it intellectually challenging. Because both the discount rate and growth rate are assumptions, inaccuracies in one or both inputs can provide an improper value. The difference between the two values in the denominator determines the terminal value, and even with appropriate values for both, the denominator may result in a multiplying effect that does not estimate an accurate terminal value. Also, the perpetuity growth rate assumes that free cash flow will continue to grow at a constant rate into perpetuity. Consider that a perpetuity growth rate exceeding the annualized growth of the S&P 500 and/or the U.S. GDP implies that the company's cash flow will outpace and eventually absorb these rather large values. Perhaps the greatest disadvantage to the Perpetuity Growth Model is that it lacks the market-driven analytics employed in the Exit Multiple Approach. Such analytics result in a terminal value based on operating statistics present in a proven market for similar transactions. This provides a certain level of confidence that the valuation accurately depicts how the market would value the company in reality.

On the other hand the Exit Multiple approach must be used carefully, because multiples change over time. Simply applying the current market multiple ignores the possibility that current multiples may be high or low by historical standards. In addition, it is important to note that at a given discount rate, any exit multiple implies a terminal growth rate and conversely any terminal growth rate implies an exit multiple. When using the Exit Multiple approach it is often helpful to calculate the implied terminal growth rate, because a multiple that may appear reasonable at first glance can actually imply a terminal growth rate that is unrealistic.

In practice, academics tend to use the Perpetuity Growth Model, while investment bankers favor the Exit Multiple approach. Ultimately, these methods are two different ways of saying the same thing. For both terminal value approaches, it is essential to use a range of appropriate discount rates, exit multiples and perpetuity growth rates in order to establish a functional valuation range.