Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 12

Closure in Valuation: Estimating Terminal Value

In the previous chapter, we examined the determinants of expected growth. Firms that reinvest substantial portions of their earnings and earn high returns on these investments should be able to grow at high rates. But for how long? And what happens after that? This chapter looks at two ways of bringing closure to a valuation: a going concern approach, where we assume that the firm continues to deliver cash flows in perpetuity and a liquidation approach, where we assume that the business is shut down and the assets are sold at some point in time.

Consider the going concern approach first. As a firm grows, it becomes more difficult for it to maintain high growth and it eventually will grow at a rate less than or equal to the growth rate of the economy in which it operates. This growth rate, labeled stable growth, can be sustained in perpetuity, allowing us to estimate the value of all cash flows beyond that point as a terminal value for a going concern. The key question that we confront is the estimation of when and how this transition to stable growth will occur for the firm that we are valuing. Will the growth rate drop abruptly at a point in time to a stable growth rate or will it occur more gradually over time? To answer these questions, we will look at a firm's size (relative to the market that it serves), its current growth rate, and its competitive advantages.

We also consider an alternate route, which is that firms ...