## Exit Multiple Overview, Terminal Value, Perpetual Growth Method

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One of the most important and challenging aspects of discounted cash flow (DCF) valuation is choosing an appropriate exit multiple. This is the ratio of enterprise value to a financial metric, such as EBITDA or revenue, that is used to estimate the terminal value of a company. How do you communicate and justify your exit multiple assumptions to stakeholders and investors? Several of our comparable companies have high forecast growth over the period to year 5, the terminal year of the explicit forecast in our DCF model (based on the default data when you first load the page). This means that the year 1 prospective multiple will be high and not suitable as an exit multiple for the company being valued, where we have an assumption of long-term growth of just 2%.

In that case, the terminal value is calculated as five times the company’s average EBIT over the initial forecast period. Over time, economic and market conditions will impact a company’s growth rate, so the calculation of terminal value tends to be less accurate as projections are made further into the future. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy. As you will notice, the terminal value represents a very large proportion of the total Free Cash Flow to the Firm (FCFF). In fact, it represents approximately three times as much cash flow as the forecast period.

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But to answer your original question, yes I think it would be a bit odd theoretically speaking to use the average EBITDA multiple for terminal value if your claim is that your company has fundamentally different business risk from its comps. Remember that multiples are really factors of 3 things – growth, profitability and risk, and so ideally speaking a good comp set should be able to tell you something about both valuation (multiples) and risk (betas). The terminal value is the value of an investment at the end of the explicit forecast horizon. It assumes perpetual cash inflows because we cannot reasonably predict future cash flows after a certain point. For example, changing the growth rate or discount rate, even by one percent, can have a material effect on the enterprise value. After a set number of years, forecasting becomes unreliable and often unrealistic, especially in high growth companies that can’t sustain such rapid growth indefinitely.

- This way, fewer additional assumptions are needed on the future course of the company beyond the forecasted years.
- It is best to verify and adjust assumptions related to growth, cost of capital, or both in such a situation.
- But to answer your original question, yes I think it would be a bit odd theoretically speaking to use the average EBITDA multiple for terminal value if your claim is that your company has fundamentally different business risk from its comps.
- For example, comparable company 1 has a year 1 prospective EV/NOPAT multiple of 20x.
- Note the appropriate cash flows to select in the range should only consist of future cash flows and exclude any historical cash flows (e.g., Year 0).

An approximation of this forward multiple can be calculated by applying a free cash flow yield in place of the explicit forecast of cash flows. A con of the Exit Multiple Method is that it infects an intrinsic valuation tool (the DCF) with relative valuation (trading multiples). This means that market sentiment ends up impacting your analysis, which is meant to be independent of the current market’s outlook on the company.

## Comparable company multiplies should be forward priced

Investors generally view a lower EV/EBIT as a more attractive sign to invest in a company, as it means that share prices are lower than the fair value of the business. Eventually, when the market attaches a more appropriate value to the company, investors would expect the share price to climb. In contrast, a high EV/EBIT may be an indication for investors to exit their investment or to short the stock.

But compared to the perpetuity growth approach, the exit multiple approach tends to be viewed more favorably because the assumptions used to calculate the TV can be better explained (and are thus more defensible). However, the structure of the NPV calculation using DCF analysis requires an additional cash flow projection beyond the given initial forecast period. Without including this second calculation, an analyst would be making the unreasonable projection that the company would simply cease operating at the end of the initial forecast period. It is also common to see stock-based compensation excluded from adjusted profit.

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To overcome this limitation, analysts assume that the cash flows grow at a specified constant rate. Starting with the growth in perpetuity approach, we can back out the implied exit multiple by dividing the TV in Year 5 ($492mm) by the final year EBITDA ($60mm), which comes out to an implied exit multiple of 8.2x. The growth rate in the perpetuity approach can be https://personal-accounting.org/capital-lease-definition/ seen as a less rigorous, “quick and dirty” approximation – even if the values under both methods differ marginally. The exit multiple approach applies a valuation multiple to a metric of the company to estimate its terminal value. But if the cash flows are levered FCFs, the discount rate should be the cost of equity and the equity value is the resulting output.

The most commonly used multiple is EV/EBITDA, which is known as the enterprise multiple. The method assumes that the value of a business can be determined at the end of a projected period or at the ‘exit’, based on the existing public market valuations of comparable companies within an industry. An exit multiple is one of the methods dcf exit multiple used to calculate the terminal value (TV) as an input to the discounted cash flow (DCF) formula which in turn is used to arrive at the current value of the business in question. An exit occurs when an owner or investor decides to end their involvement with a business, most often by selling their ownership stake to other investors.

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