8 July, 2021

How to Choose and Justify Exit Multiples

In the last twelve months (LTM), EBITDA was $50mm and unlevered free cash flow was $30mm. Here, the terminal value is calculated by treating a company’s terminal year FCF as a growing perpetuity at a fixed rate. The result of forward pricing is a median multiple of 11.0x for the 7 https://personal-accounting.org/adp-run-review-features-pricing/ comparable companies. This compares with a median current multiple of 19.0x, the application of which would have led to a significant over valuation. The forward priced multiple is the calculated forward EV divided by a forecast metric such as EBITDA for a related forward period.

dcf exit multiple

The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has a mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). Analysts use exit multiples to estimate the value of a company by multiplying financial metrics such as EBIT and EBITDA by a factor that is similar to that of recently acquired companies. A disadvantage of using the Perpetuity Method is that it is not well suited for all companies.

What is the Exit Multiple DCF Terminal Value Formula?

We strongly disagree with this adjustment for performance measurement and even more so for DCF valuation. The argument that SBC is non-cash, and therefore cannot affect DCF values, is false. It is essential to include forecast SBC in free cash flow AND deduct the value of outstanding stock options in the bridge to equity value to fully reflect this in a target stock price. For more about effective cash flows and the analytical implications of stock-based compensation see our articles When cash flows should include ‘non-cash flows’ and Dot-com bubble accounting still going strong.

  • It is used assuming that the investment has an infinite horizon as well as constant growth rates and discount rates.
  • Commonly used terminal multiples include EV/EBIT and EV/EBITDA which can be found online or calculated from company financial statements.
  • But even though the approaches are vastly different, they have more in common than we might think.
  • It is also common to see stock-based compensation excluded from adjusted profit.

While an entry multiple is a price paid for a company relative to a financial metric, an exit multiple is simply the sale price of a company relative to a financial metric. Both EV/EBITDA and EV/EBIT are popular financial ratios that essentially measure the value of a company in relation to its profits. The major difference between the two metrics is that EV/EBIT includes depreciation and amortization, which is particularly useful while analyzing capital-intensive businesses where depreciation is a true economic cost.

How to Calculate Terminal Value

However, in our view, the analysis and the rationale for selecting the stated exit multiple range would have been clearer if the forward price multiples of the comparable companies had been presented. Fairness opinions provided at the time of business acquisitions generally include DCF valuations and often these feature terminal values based on observed comparable company multiples. The extracts below are from the offer document for the purchase of Tiffany by LVMH in 2020.

For more about forward priced multiples, and for a model illustrating alternative approaches to their calculation, see our article Why you should ‘forward-price’ valuation multiples. The discounted cash flow model (DCF) is used by analysts when valuing a business and consists of 2 major components; the present value (PV) of its future cash flows, and its TV beyond the forecast period. The TV can be computed in 2 ways, the Gordon Growth Model and the exit multiple/terminal multiple method.

Guide to the Discounted Cash Flow DCF Formula

The ratio is particularly useful for comparing a company with its competitors within the wider market. A multiple, also called a multiplier, is a valuation technique that calculates the value of a business or company relative to a financial metric. Multiples are used to compare businesses operating in similar environments such as the same sector to determine whether a company is reasonably priced, as compared to its peers. There are numerous types of multiples that can be used, a few of which include EV/EBITDA, EV/Sales, EV/EBIT, P/BV, and P/E multiples. However, the most commonly used multiples are EV/EBITDA and EV/EBIT as they provide a direct relationship between enterprise value in relation and the profits of the company which in most cases can be standardized. The model below is an extract from a larger downloadable spreadsheet in which we provide five alternative approaches to the calculation of a DCF terminal value.

  • The Gordon Growth Model (GGM) assumes that a company will exist indefinitely and is consistent with the going concern assumption of financial reporting.
  • In the subsequent step, we can now figure out the implied growth rate under the exit multiple approach.
  • Generally, the FCF yield approach should produce forward priced multiples that do not materially differ from those using an explicit cash flow forecast, especially if the forward look period is relatively short.
  • In fact, it represents approximately three times as much cash flow as the forecast period.
  • The DCF method assumes that the asset value equals the future cash flows generated by that asset.
  • However, the most commonly used multiples are EV/EBITDA and EV/EBIT as they provide a direct relationship between enterprise value in relation and the profits of the company which in most cases can be standardized.

Anything beyond that becomes a real guessing game, which is where the terminal value comes in. There is no right answer to the question of which multiple is the best basis for a terminal value in an enterprise DCF valuation. Any profit, cash flow, asset or indeed other activity metric could conceivably be used.

What is discounted cash flow?

It’s possible to derive equity value by subtracting any debt and adding any cash on the balance sheet to the enterprise value. As mentioned above, the terminal growth rate should not exceed the historical growth rate of the overall dcf exit multiple economy (GDP) and should be roughly in line with inflation. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

  • Investors use WACC because it represents the required rate of return that investors expect from investing in the company.
  • Therefore, the accuracy of the cash flows in year n is partly dependent on the accuracy of all the cash flows from year 0 to year n.
  • The exit multiple assumption is usually developed based on selected companies’ trading multiples.
  • To be conservative, we’ll be using 2.5% as the long-term growth rate assumption.