Estimating Terminal Value using a Two-Stage Value Driver Model

Two-Stage Value Driver

When using the Discounted Cash Flow (DCF) Valuation Method, Terminal Value represents a business’s estimated continuing enterprise value beyond an explicit forecast period. It typically is estimated at the end of year 5. In many cases, Terminal Value includes 60% – 70% of business valuation in a standard Discounted Cash Flow model. Choosing which Terminal Value model to use for its estimation is essential. There are various methods for estimating terminal values. In this article, we will present one of the more sophisticated methods to estimate Terminal Value – the Two-Stage Value Driver Model.

The fundamental concept of such a value driver model is to forecast better how revenues and cash flows are expected to develop in the terminal value period. Like products, businesses typically follow a life cycle model with startup, growth, maturity, and decline phases. If a business is in a growth stage today, it is fair to assume that the business will mature, and profits might also decline at some point. The key variable here is the business’s competitive advantage, which allows it to generate excess returns (defined as ROIC being higher than the Weighted Average Cost of Capital (WACC)) and its duration. 

Financial analysts use the return on invested capital (ROIC) metric to evaluate capital funding decisions because the ratio shows the ability of a company to generate profits through the capital invested. ROIC is calculated by dividing net operating profit less adjusted tax (NOPLAT) over the average invested capital. Please refer to these articles, which explain more about the ROIC and the WACC.

The Two-Stage Value Driver Model allows us to project our terminal value’s free cash flows depending on the length of a competitive advantage period, the return on invested capital (ROIC), and the company’s expected future growth in the terminal value year. The way this is done is that we differentiate two phases in the terminal value:

  • Stage 1: Where the business enjoys a competitive advantage, typically with high ROIC and high growth.
  • Stage 2: Where the competitive advantage is gone. The ROIC rate will be close to the WACC, and the growth rate will be lower or even zero.

Modeling terminal value this way allows us better to capture the key value drivers of the business and come up with a more sophisticated justification for the terminal value than other terminal value valuation models. The uniqueness of this approach is that we have to consider the duration of the competitive advantage period and focus our attention on ROIC and growth.

To further understand what is to be explained in this article, you may download our Free DCF Valuation model template.

The Drivers of Terminal Value

Value drivers are those factors that significantly impact terminal value. The following are the key value drivers used in the estimation of terminal value by the Two-Stage Value Driver Model:

  1. Growth Rate – Annual percentage of revenues (Stage 1) and Free Cash Flows (Stage 2) are expected to grow.
  2. Invested Capital – The capital required to produce the cash flows is usually expressed as an efficiency ratio – how much the invested capital can produce sales. Invested capital is assumed to be the same as capital employed. Therefore, changes include investments in both fixed assets and net working capital.
  3. ROIC – Measures the return on the invested capital and is frequently used by financial analysts to compare and benchmark the operating profitability of a business over time and with peer companies. In a DCF Valuation, typically at the end of the 5-year forecast period, ROIC can be significantly higher than the WACC. We need to clarify the expected starting ROIC in Stages 1 and 2 in our Two Stage Terminal Value model.
  4. Duration of Competitive Advantage Period – There is a need to estimate how long a company expects to produce superior returns compared to its peer companies by looking at stock market returns or data from publicly listed companies. It might not be easy to estimate, but n light of past similar companies or business life cycles, companies may make the best realistic assumption.
  5. ROIC Curve – ROIC is estimated separately for Stages 1 and 2. The primary purpose of the two stage value driver model is to eliminate non-realistic excess returns in Stage 2. we typically have to model a decline in ROIC from the beginning of Stage 1 to the start of Stage 2. In Stage 1, assuming an expected behavioral curve, ROIC will decline from the beginning up to the start of Stage 2. These are some curves that are used:
    • Steady Decline: ROIC will steadily decline until it reaches the ROIC in stage 2.
    • Exponential Decline: ROIC will start to decline slowly but faster thereafter (exponentially)
    • Decline Jump at End: ROIC will remain stable over the years until it suddenly drops to the ROIC in stage 2.
  6. Discount Rate – Unless there are specific reasons, the discount rate (measured via the company’s WACC) should not change and should remain the same for the whole DCF Valuation exercise.

Two Stages for Estimating Terminal Value

As mentioned above, the terminal value period is split into two stages in our two-stage Terminal Value model. Therefore, we will require different assumptions for each stage:

We need to know how long the competitive advantage period will last in stage 1 to set when Stage 2 will begin. Assuming that the final explicit forecast year is year 5 and the competitive advantage period is 15 years, the terminal period will start in year 6, and Stage 1 will end by year 20.

The discount rate is assumed to be the same as we use for the DCF valuation.

Growth rates can be estimated separately, but for discussion purposes, both growth rates in Stages 1 and 2 are assumed to be the same, focusing mainly on the effect of declining ROIC. In case there is a higher growth assumed in phase 1, please be aware that growing revenues will require higher investments which in some cases even can lead to lower free cash flows. Generally, CAPEX is required to drive higher growth.

ROIC, which can be calculated during the 5-year explicit forecast period by dividing NOPLAT by the Invested Capital, now becomes an input and not an output anymore. The terminal value model’s yearly forecasted free cash flow depends on the ROIC. Therefore, it is necessary to identify the target ROICs for Stages 1 and 2. In Stage 2, we estimate the remaining spread to the Discount Rate. We also hypothesized that in the long-term, the ROIC should be the same as the WACC, ergo no spread to the Discount Rate anymore in Stage 2.

Finally, determine how the difference in ROIC will be bridged between Stage 1 and Stage 2 by setting the expected cure on how ROIC is expected to develop during the competitive advantage period in Stage 1.

Stage 1

Start forecast in Stage 1 by projecting revenues and the required invested capital. Then by inputting the yearly ROIC targets, we can roll up our forecast to specify the yearly NOPLATs, Free Cash Flows, and profit (EBITDA) targets.

The ROIC rate in the first stage declines towards the historical discount rate, depending on the selected ROIC curve method. ROIC rate does not decline in drastic steps but follows a trend or type of curve before it stabilizes at a new rate.

ROIC Curve Methods and Effect in FCF

The above-mentioned assumptions will be illustrated in the example below to explain the impact of Free Cash Flow Forecast during the Terminal Value years. Charts below plot ROIC and the resulting annual Free Cash Flows. As you can see in all models, ROIC will decline to the WACC at the beginning of Stage 2 in year 20. Let’s now look at how each ROIC curve will impact the Free Cash Flow forecast during the Terminal Value years.

1) Steady Decline – The difference between the initial ROIC rate and the ending ROIC rate is equally divided through the competitive advantage years. The ROIC then declines at that constant annual rate, resulting in a constant decrease in the FCF in stage 1 before they grow again at the beginning of stage 2 (year 20).

2) Exponential Decline – The decrease in ROIC rate is slower at the beginning than at the end, resulting in Free Cash Flows declining over time until they stabilize in stage 2. Please note that the Free Cash Flows might be lower if a high growth rate is assumed (as we assume that growth requires CAPEX to trigger such). Free Cash Flows decrease in Stage 1 as the ROIC decreases until they stabilize in stage 2 and start to grow again at an ROIC equal to the WACC in year 20.

3) Decline Jump at End – ROIC is assumed to remain steady throughout the competitive advantage period in stage 1. Since revenues constantly increase at the assumed growth rates of 2.5% per annum, FCF will also increase during stage 1 and stage 2 (but ROIC remains constant). At the end of Stage 1, we expect our competitive advantage to disappear suddenly, leading to a significant drop in Free Cash Flows at the beginning of stage 2 in year 20.

Terminal value in stage 1 is calculated by summating the discounted yearly free cash flow during the competitive advantage period.

Stage 2

Beyond the final explicit duration of competitive advantage, ROIC remains constant, and free cash flows are increasing continuously at the assumed growth rate of 2.5%. Terminal value is estimated using the standard calculation by dividing the end of duration of the competitive advantage’s free cash flow over the difference between the discount rate and growth rate:

Below illustrates the detailed computation for estimating the terminal value:

Terminal Value Result from a Two-Stage Value Driver Model

Stage 1 calculates the discounted value of the free cash flow per year during the competitive advantage period, while Stage 2 estimates the terminal value beyond the assumed duration of competitive advantage by only taking the free cash flow at the end. The values for Stages 1 and 2 are discounted to their present values at the end of year 5.

The total discounted value from both stages is the estimated terminal value using a Two Stage Value Driver model. 

The Difference between Gordon Growth and the Two-Stage Value Driver Model

The two stage value driver model requires more assumptions and is more complex to model than a simple Gordon Growth model. Why all this effort? Why are we not using a Gordon Growth Terminal Value model?

The main issue of Gordon Growth is that if the ROIC at the end of the forecast period is significantly higher than the WACC, then a Gordon Growth model will capitalize on this high ROIC forever. Assuming that a high spread between ROIC and WACC will remain forever, it would be unrealistic and, in most cases, will be overstating terminal value.

To illustrate the difference, the implicit assumed Free Cash Flows between a Gordon Growth model and a Two Stage Value Driver model in the terminal Value years are compared below:

As illustrated above, Gordon Growth implicitly assumes much higher Free Cash Flows than our Two Stage Value Driver model. Such high cash flows are unrealistic since this would mean that the business will not follow a normal life cycle. Just take the example of Kodak, everybody thought they had a solid business model, and once digital cameras emerged, their competitive advantage suddenly disappeared. Therefore, it is essential to consider the effect and duration of competitive advantage measured with the ROIC and its difference with the WACC.

Two-Stage Value Driver Model: A very sophisticated approach to estimating Terminal Value

Compared to other methods of estimating terminal value, the two stage value driver model requires more assumptions than other terminal value models. We need additional estimates of the important key value drivers, such as the length of the competitive advantage period in Stage 1, and assumptions for both stages, such as the growth rate and ROIC. The calculations are also more complex because there is a need to forecast the calculation of annual free cash flows for two periods – not only for a five-year forecast period but also during the Terminal Value years. Despite requiring more work, using eFinancialModels’ Excel spreadsheet template that includes a Two Stage Value Driver model will eliminate the issue regarding the complex work.

An advantage of using a Two-Stage Value Driver model is we can obtain a much deeper understanding of how the Terminal Value in a DCF valuation model is composed. Instead of simplifying Terminal Value artificially, such as Gordon Growth, which in most cases will assume unrealistic profits during the Terminal Value years, a Two-Stage Value Driver model allows us to fine-tune the real drivers of cash flows. A company’s ROIC and growth rate and distributed over two phases. Therefore, we can now obtain a more sophisticated argumentation and an additional data point on what a Terminal Value could result.

To fully follow and understand the explanations outlined in this article above, download the sophisticated version of our Free DCF Valuation model template in Excel.


Was this helpful?