Valuation course · Lesson 6 of 10
Most of the value is in the years after year 10.
No model can project every year. So a DCF stops at year 10 and puts one value on all the years after. That one value is usually most of the answer.
The formula
After year 10, we assume that NOPAT grows 3% a year forever. Then the value of all the later years is the cash flow in year 11, divided by the hurdle less the growth rate. This is the constant growth formula.
For Example Co., the value at the end of year 10 is $3,644 million. Today, it is worth $1,539 million. That is 62% of the value of the business.
Small changes, large effects
| Growth after year 10 | 8% hurdle | 9% hurdle | 10% hurdle |
|---|---|---|---|
| 2.0% | $26.54 | $22.22 | $19.00 |
| 2.5% | $27.78 | $23.01 | $19.52 |
| 3.0% | $29.28 | $23.92 | $20.11 |
| 3.5% | $31.10 | $25.00 | $20.79 |
The gap between the hurdle and the growth rate is in the denominator. When the gap is small, a small change has a large effect. Keep long-run growth below the long-run growth of the economy.
The return after year 10
Our base case assumes that new capital still earns 24.0% after year 10. If new capital earns only the hurdle, growth adds nothing after year 10. Then the value falls to $20.26 from $23.92.
Check the result as a multiple. Our terminal value is 11.5 times operating income in year 11. If that multiple looks high for a mature company, an assumption is too high.
Key points
- The terminal value is usually most of a DCF.
- Keep long-run growth low, and check the result as a multiple.
- Ask what new capital earns after year 10. At the hurdle, growth adds nothing.
Sources
- Myron J. Gordon, Dividends, Earnings, and Stock Prices, The Review of Economics and Statistics, 1959, for the constant growth formula.