If you are using the discounted cash flow method for your business valuation, a key step is to calculate the terminal value. This is the residual value of the company assuming that it will continue operating beyond the earnings projection period.
The idea is that you can predict business earnings only so far into the future. Beyond a certain point the accuracy of forecast becomes questionable. So it is reasonable to make some assumptions about how business will continue going forward.
The constant growth model assumes that the company will continue operating with earnings increasing at a some fixed rate of growth. So instead of discounting the business cash flows indefinitely, you can simply apply a capitalization formula to calculate the terminal value.
While the constant growth model is the usual way to calculate the terminal value, there are some alternatives you may want to consider. Here are some suggestions:
Sum of book value of debt and equity
The terminal value is just the sum of the two. Of course, the main assumption here is that the firm’s book values accurately predict its market values.
Multiple of market to book value
Terminal value = (market / book multiple) x (book value of debt and equity)
Price to earnings ratio formula
Terminal value = Price to earnings ratio x profits + book value of debt.
The profits and book value of debt are estimated as of the end of your earnings forecast period.
EBITDA based ratio formula
Terminal value = EBITDA ratio x expected terminal EBITDA.
The terminal EBITDA is what you expect to see at the end of the cash flow forecast.
Since the discounted cash flow method calculation includes the terminal value explicitly, you can substitute one formula for another in your business valuations.
Here is an example of using the discounted cash flow method that explains how the terminal value enters into the calculation.
See Example »
General auto repair shops make up a large portion of the auto services industry. Given the number of vehicles on the road, this is no luxury business with customers needing either repair or maintenance on a regular basis.
Independent auto repair shops are usually privately owned and focus on a number of essential services for the ever growing pool of cars.
Take a look at some key industry statistics. There are over 81,600 companies in this line of business in the USA alone, classified under NAICS code 811111 and SIC 7539. Combined, the auto service centers produce $37.7B in annual revenues. The average auto repair shop is $462,000 with a staff of 4.
Successful auto service centers develop strong reputation and loyal customer following in their market. These companies act as experts who are able to advise and address a wide range of customer concerns. Unsurprisingly, well established auto repair shops tend to command consistent earnings and higher profitability.
As you can expect, such companies often become acquisition targets selling to competitors or larger firms working to expand their market share. The selling prices that result in such deals are a good indicator of what the companies are worth.
To value any other auto repair business, you can do a comparison against these recent sales. To do so, calculate valuation multiples that relate the business selling prices to their financial figures such as revenues, profits, cash flow, or assets.
Example: Valuation of an auto service center by multiples
A typical way to estimate the value of a company in this industry is to use the annual revenue as the key metric. To illustrate the idea, let’s take a typical company with $462,000 in annual sales and inventory on hand of $50,000.
Here are the valuation multiples we choose along with the results:
|Average Business Value
Inventory is added to the multiple result
The value results above include the inventory addition as is typical when valuing the auto repair shops.
Note that there is quite a range in our business valuation results. What makes some companies worth more than others? This is a labor intensive business involving highly specialized auto mechanics. For higher valuation multiples the staff has to be managed well to prevent defection and loss of customer following. This is a growing concern since many large car dealerships seek out skilled auto mechanics aggressively.
Availability of seasoned management over and above the owners is important as well. Such shops are easier to take over even for a someone who is not an auto repair expert. As a result, the pool of potential business buyers is larger resulting in a higher selling price.
The auto repair centers that focus on excellent customer service tend to be more valuable. People are more likely to pay for top quality service and return when the need arises. Needless to say, such return business and customer referrals lead to higher profitability and increased business value.
See an example of valuing a business using valuation multiples derived from recent business sales.
See Example »