I got involved in a friendly debate with a business intermediary the other day. He was talking cynically about how easy it is to manipulate valuation results by playing games with the cost of capital and the growth rate. “It’s easier to slap an industry multiple to it, without all the fiction of precision,” he said. Specifically, he was objecting to “terminal value” for growth companies. In growth companies, terminal value can often comprise 50%-70% of total enterprise value, so he was right to call the assumptions into question. However, according to his reasoning the whole valuation exercise is built on sketchy technical grounds. With that logic a skilled surgeon could be labeled a murderous butcher, or an accomplished poet labeled a daydreamer who never amounts to anything.
What is terminal value?
Terminal value is an attempt to capture the long term sustainable growth rate of the company and discount the company’s cash flow by its cost of capital. When a company experiences high growth, it’s certain that it will eventually mature and slower growth will ensue. The rate of slowdown is hard to predict, so it’s true that these aren’t precise calculations and they have a degree of subjectivity. However, a skilled valuation analyst will take care in applying these variables, and will use other approaches and methods to test, validate and defend his or her assumptions.
Not all companies are created equal, yet very few companies can outgrow the economy on a sustainable basis. For company risk, or its cost of capital, each company will have fundamental factors that either raise or lower its risk profile. Company growth, as mentioned above, may experience periods of non-linear growth but ultimately hit a maturation point that will be closer to the level of overall economic growth. Three to five percent is often a very defensible sustainable growth rate, depending on the company’s fundamentals and sensitivity to the broader economy.
“One advantage that Exit Strategies has over other business appraisers is that we see regular deal flow and work with actual market participants.”
Through our M&A brokerage practice, we see regular deal flow and work with actual market participants. This means that in addition to databases, we have a current market view of how companies are being valued. This helps us to gauge our income approach risk and growth assumptions with a market based view. We also consider an asset approach and make market adjustments to book value, though this approach generally is used to provide a floor to the valuation. However, it can come into play if a company isn’t using its assets efficiently and is generating sub-par returns on invested capital.
To summarize my long-winded reply to the intermediary, a skilled craftsmen has a large tool kit, knows what tools to use, when, and how to use them in each particular situation.
Exit Strategies brings independence and over 100 years of combined valuation and transaction expertise to every engagement. For a free confidential consultation on and M&A, exit planning or valuation need, please contact one of our senior advisors.