Financial Decisions - Document Index

Terminal Values For Firms With No Competitive Advantage

Tom W. Miller

Coles College of Business

Kennesaw State University

Abstract

Two-phase valuation models are often used for the value of the firm, the value of the equity, the value added by the firm, and the value added by the equity. The first phase, called the explicit forecast period, employs explicit near-term forecasts and permits a variety of different types of performance over time. The second phase, called the continuing value period, is all of the time periods after the first phase and is treated as a steady state with constant long-term relationships. Terminal value models are used to represent the value generated during the second phase, the continuing value. This research introduces fundamental models representing structural relationships within the firm into the terminal value models utilized for the second phase in these valuation models. The resulting models for terminal value incorporating fundamental structural relationships are used to analyze the significance of the growth rate during the continuing value period and the proper ways to estimate the various terminal values.

“Many financial analysts routinely assume that the incremental return on capital during the continuing value period will equal the cost of capital. This practice relieves them of having to forecast a growth rate, since growth in this case neither adds nor destroys value (e.g., Koller, Goedhart, and Wessels, 2005).” The contribution of this paper is therefore not the “discovery” of this outcome, but providing the “proof” via the derivations and results shown that this outcome holds for various terminal value scenarios focusing on the free cash flow to the firm, the free cash flow to the equity, the economic profit to the firm, and the economic profit to the equity. The significant outcome is that concerns about whether the steady-state growth rate is greater than, less than, or equal to the growth rate for the economy are unimportant during the continuing value period when the incremental return on capital equals the cost of capital.

JEL Codes: G12, G31

Keywords: Valuation, Terminal Value, Continuing Value, Value of the Firm, Equity Value