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Estimating Terminal Value using the H-Model
The H-Model is a quantitative method used to estimate the terminal value in a Discounted Cash Flow (DCF) Valuation by attempting to smooth out the growth rate over time, rather than abruptly declining to a stable growth period such as a Gordon Growth model.
- It smooths out the transition from high growth to stable low growth with a linear decline, better reflecting real-world business cycles.
- The model relies on key inputs like projected free cash flows, discount rates, and specific high and low growth rates.
- It is especially useful when companies experience a temporary high-growth phase followed by maturity.
- Compared to the Gordon Growth and two-stage models, the H-Model captures the gradual decline in growth more realistically.
- Using this approach can improve valuation accuracy and provide deeper insight into a company’s transitional growth period.
The fundamental concept of the H-Model is that it illustrates the relationship between free cash flows, discount rate (WACC), and high and low growth rates. This method assumes that the company is expected to earn excess returns over a high growth period and will eventually decline linearly to a stable low growth rate. This article explains the steps in calculating the Terminal Value using the H-Model.
A standard Discounted Cash Flow (DCF) Valuation Method typically derives a Terminal Value of 60% – 75% of the enterprise value. Since Terminal value can drive a large portion of the enterprise value and should therefore be evaluated carefully, selecting which Terminal Value model to use for its estimation is essential.
To understand the discussion in this article on how terminal value is estimated, you may download our Free DCF Valuation model template, which – among other Terminal Value models – includes the H-Model – for calculating Terminal Value.
How to Estimate Terminal Value using the H-Model
Elements that significantly impact terminal value are explained, and steps are demonstrated below to illustrate the estimation of the terminal value using the H-Model.
1) Forecast the Free Cash Flows
The first step is to project the company’s future Free Cash Flows until its financial performance has reached a normalized “steady state”. The Free Cash Flow at the end of the forecasted period (Year 5) serves as the basis of the terminal value under the Gordon Growth Model.
2) Use the Discount Rate from the DCF Valuation Model
In this article’s illustration, WACC is used as the discount rate since it determines the value of future free cash flows of an enterprise or firm.
Understand WACC further by visiting this link: Calculating the discount rate for Discounted Cash Flow Analysis
3) Estimate a High and Low Growth Rate
It is realistic to assume that a company will continue to grow at a high rate for only a few years because its competitive advantage is temporary. The growth will then eventually decline linearly to stable low growth.
Under the H-Model, to estimate the terminal value of a company, the high and low growth rates are attached to the forecasted cash flows of a company after the explicit forecast period to determine how these cash flows are expected to grow in all future years.
4) Determine the High Growth Period
The high growth period is the expected period a company is at its peak due to its competitive advantage, earning excess returns.
5) Estimate Terminal Value
Below are the values you need to be familiar with to calculate the Terminal Value in a Discounted Cash Flow:
FCFTV – Free Cash Flows at year-end of the forecast period (Year 5)
WACC – Weighted Average Cost of Capital or the discount rate
gL – Low growth rate of FCF
gH – High growth rate of FCF
H – Period of High Growth Period divided into half
The detailed computation of terminal value using the H-Model assumptions mentioned above are calculated below:
To summarize, below are the parameters and the resulting Terminal Value based on the H-Model:
H-Model Considers Growth Periods and Rates
The Gordon Growth model assumes that free cash flows will continue to grow indefinitely at a constant growth rate, which is unrealistic in this continuously growing business world. The H-Model, an upgraded version of the Gordon Growth Model, was invented to consider the changes in growth periods due to temporary competitive advantage.
Another alternative approach that considers the duration of competitive advantage is the Two-Stage Value Driver Model. The two-stage value driver assumes an extraordinary growth phase during Stage 1 and a constant growth phase in Stage 2. In contrast to the two-stage value driver model, the H-Model’s growth rate is not constant during the high growth period and gradually reduces to a constant low growth rate.
The H-Model is a perfect tool for estimating terminal value through the transition from the high growth period to the sustainable growth period.
Download eFinancialModels’ sophisticated version of the Free DCF Valuation model template in Excel, which includes a variety of advanced Terminal Value Formulas, including the H-Model. Downloading this spreadsheet template allows you to compare the results using different Terminal Value Formulas and see their contribution to the overall Enterprise Value in a DCF Valuation result (typically between 60% to 70%). Surprise your investors and stakeholders using one of the advanced Terminal Value methods.
If you’re looking for financial model templates that include a DCF Valuation, please feel free to check out our full list of DCF Model templates here:
