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DCF Analysis Calculating Terminal Value

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                <p>In order to capture the value of a company beyond its
free cash flows in a DCF analysis, one must calculate the company's
terminal value. Let's take a look at how to do so.</p>
<p>If we were to take the net present value of a company's projected free
cash flows (FCF) five years out into the future, we would be grossly
understating the value of the company. We would be leaving out the value
of the company's projections beyond five years. In order to capture this
value, we need to calculate the company's terminal value (the value of
the company in year five or the last year in a DCF analysis).</p>
<p>Terminal value can be calculated a couple of ways - with a perpetuity
calculation or an exit multiple calculation. The perpetuity calculation
is like a mini DCF analysis of the company's FCF off into infinity. The
calculation of the perpetuity value is as follows:</p>
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<p>Cash Flow in Terminal Year / (WACC - Long-Term Growth)</p>
<p>The exit multiple method is similar to a comparable companies
analysis. You pick a valuation multiple for data point you have projected
and multiply it by the data point to get the company's valuation at that
point in time.</p>
<p>If we were to use the exit multiple method, we could simply multiply
our EBIT value in year five of the projections by a multiple of seven to
calculate our terminal value. We can get an accurate multiple for this
hypothetical company by pulling a few public comps and seeing where the
range of multiples currently falls in today's marketplace.</p>
<p>Finally, we add this terminal value to our cash flow in year five to
get our five years of free cash flows. Now all we need to do is discount
these projections by the company's WACC to determine the enterprise
value.</p>
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