Estimating the terminal value of Disney

Estimating the Terminal Value

The approach most consistent with a DCF model assumes that cash flows beyond the terminal year will grow at a constant rate forever, in which case the terminal value can be estimated as follows:

Terminal value at n= Free cash flow to the firm at (n+1) / (Cost of Capital at (n+1) – g at n)

Example) Disney’s terminal value after year 10
Disney’s FCFF at year 11= 9086
Cost of capital at year 10= 0.0729

Growth rate at year 10 = 2.50

Terminal value = FCFF₁₁/ (Cost of capital_{stable growth}- g)
                       = 9086/(0.0729-0.025) = 189,738 million

Where the cost of capital and the growth rate in the model are sustained forever. We can use the relationship between growth and reinvestment rates that we noted earlier to estimate the reinvestment rate in stable growth:

Reinvestment rate in stable growth= stable growth rate/ ROC at n

Where the ROC at n is the return on capital that the firm can sustain in stable growth.

In every DCF valuation, there are two critical assumptions we need to make on stable growth.
1. When the firm we are valuing will become a stable-growth firm, if it is not one already.

1.     What the characteristics of the firm will be in stable growth, in terms of return on capital and cost of capital.

As we noted with equity valuation models, high-growth firms tend to be more exposed to market risk (and have higher betas) than stable growth firms. Thus, although it might be reasonable to assume a beta of 1.8 in high growth, it is important that the beta be lowered, if not to one at least toward one in stable growth.

High growth firms tend to have high return on capital and earn excess returns. In stable growth, it becomes more difficult to sustain excess returns. There are some who believe that the only assumption sustainable in stable growth is a zero excess return assumption; the return on capital is set equal to the cost of capital. Although we agree in principle with this view, it is difficult in practice to assume that all investments, including those in existing assets, will suddenly lose the capacity to earn excess returns. Because it is possible for entire industries to earn excess returns over long periods, we believe that assuming a firm’s return on capital will move toward its industry average sometimes yields more reasonable estimates of value.

Finally, high-growth firms tend to use less debt than stable growth firms. As firms mature, their debt capacity increases. The question of whether the debt ratio for a firm should be moved toward its optimal cannot be answered without looking at the incumbent managers’ power relative to their stockholders and their views about debt. If managers are willing to change their debt ratios and stockholders retain some power, it is reasonable to assume that the debt ratio will move to the optimal level in stable growth; if not, it is safer to leave the debt ratio at existing levels.

As firms mature, their debt ratio increases

Different sectors have different beta levels