Terminal Value is not always evil

I have always enjoyed reading Professor Aswath Damodaran's lengthy blogposts on valuation, not only because that I enjoy in general lengthy and complicated analysis, but also because I had trained myself very seriously in financial theories (passing all 3 levels of CFA exams in 18 months and would like to keep myself sharpened. Doing this definitely helps me keep a sanity in doing investments, not to be swayed by the market – even if ours is a private one – too much.

Prof. Damodaran's recent article entitled « Myth 5.5: The Terminal Value ate my DCF! », however, raised a very interesting point on the subject of Terminal Value in DCF valuation.

Like many professional financiers, I've always seen Terminal Values that account for a large chunk (80%~90%) of the current valuations as a sign that these particular valuations are not reliable. I swear by this especially that most of the time I do FCFF (Free Cash Flow to the Firm) & EV (Enterprise Value) valuations, instead of FCFE (Free Cash Flow to Equities) & MVE (Market Value of Equities).

However, Prof. Damodaran pointed out that it's normal that in FCFE valuations Terminal Values account for a large part of the current valuations simply because empirically public market shareholders get much more returns from capital gains than dividends.

Screen shot from Prof. Damadaran's « Myth 5.5: The Terminal Value ate my DCF! »,

In other words, most of the FCFFs generated by the operating activities of US companies historically stayed in the firms (instead of being paid out as dividends to shareholders) and were invested in projects that generated more values, which in turn generated more FCFFs, etc.

That said, I believe that this is not the case in FCFF & EV valuations, as there's no effect on how the FCFF is distributed if we exclude tax impacts. I would say that if the Terminal Values in your FCFF models account for huge part of your EVs, the models are still unreliable. This is the case of many LBO modelings where revenue growths are modeled only up to 5 years and also to be low single-digits.

In the case of high-growth startup modeling, it's important to project FCFFs up to 10 years or 20 years until the company hits maturity. If after doing all this a significant portion of the EV still comes from Terminal Values, then this model is just as unreliable as a 5-year LBO one, if not more.

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