Long-term growth rate assumptions for terminal values can cause exit multiple mistakes

BVWire–UKIssue #32-1
November 2, 2021

DCF models are becoming more accepted in UK business valuations, and several experts note that mistakes happen when analysts don’t consider the reasonableness of the implied long-term growth rate embedded in the selected exit multiple. For most businesses, it’s unlikely that the growth rate during the next few years will be sustained at exit or in a terminal value calculation—though owners and investors often wish it was. In fact, both the growth rate and the valuation date multiples calculated at the valuation date nearly always need to be reduced because of the increased risk and uncertainty of cash flows in the future (typically, three to five years in many DCF analyses).

Jim Hitchner, the US-based valuation expert, prepared the following table of the long-term growth rates to support exit multiples of 3 to 8 in the current edition of his Hardball With Hitchner newsletter. It’s extremely rare that any company exceeds the economic growth rate in perpetuity after five years, so, referring to Hitchner’s analysis, a growth rate assumption implied by an exit multiple higher than 3 would seem optimistic. Still, the M&A market would balk at such a low exit value in any projection, where often 8 times EBITDA seems to be the floor, and higher multiples are frequently assumed.

 Exit multiple derived from listed comparables Implied long-term growth rate
 8 12.9%


Hitchner points out that higher assumed exit multiples create the situation where “the terminal value is higher than the present value of the interim cash flows.” In these valuations, it could be argued that the single biggest determiner of value in a DCF analysis is the financial expert’s terminal growth rate assumption.

The Footnotes Analyst also examined the exit multiple problem in a series of articles last month. “If a valuation multiple, such as EV/EBITDA, is used to calculate a DCF terminal value, the multiple should reflect expected business dynamics at the end of the explicit forecast period and not at the valuation date,” the authors say. “This is best achieved by basing the exit multiple on forward-priced multiples for the selected group of comparable companies,” which they demonstrate with a series of examples. They also include an interactive model that business valuers can employ to calculate their own DCF terminal values using forward-priced multiples.

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