We invest in a company in the hope of generating wealth. This is not a quick process but takes place over numerous years. We must accept that this firm is, hypothetically, a continuing venture. Even though I’m not personally fond of the assumption, the discounted cash flow model assumes that it will exist indefinitely.
Let us assume this is true for now.
We can project cash flow for the next five years but also anticipate that the company will exist for much longer, so there would be a continuous cash flow timeline.
When we project the cash generated over the next five years, we consider a specific growth rate. To account for future earnings, we must apply a similar growth rate beyond year five into perpetuity.
The growth rate is referred to as ‘The terminal value growth rate’, which usually matches the long-term inflation rate. Did you notice this so far?
For the initial five years of our model, we conduct a comprehensive evaluation of the cash flow.
Once we reach the fifth year, it is no longer necessary to conduct a detailed analysis; rather, we can simply assume cash flow to increase in perpetuity (terminal value).
The underlying presumption is that the cash flow beginning in the 5th year will remain constant and yield a positive outcome. If the cash flows are negative, discounted cash flow analysis will be ineffective.
Once we have the terminal value growth rate, equal to the long-term inflation of the country, we can compute the present value of each future cash flow by applying a discount rate. This rate could be either the return expectation of equity investors or that of the firm (WACC). To calculate the present value of infinite future cash flows, however, we cannot use the standard present value formula. Consequently, a specific formula needs to be used in this case –
Present value of Terminal Value = C (1+ g)/(r-g)
C = cash as of today
g = growth rate, i.e. inflation rate
r = discount rate (either for equity investors or the firm as such)
We won’t go into the details of how to derive the formula right now. However, let us consider what we are attempting to accomplish. Starting from year five and afterwards, in perpetuity, let’s look at the cashflow.
6th Year – FCF is 50Cr
7th Year – FCF is 53 Cr
8th Year – FCF is 55 Cr
You essentially calculate the lump sum amount you must pay today, in order to receive a stream of cash flow in the future. This calculation continues infinitely.
I hope you understand what we have been trying to discuss. If anything is still unclear, feel free to re-read this chapter. We will then move on to the next step and put all our knowledge into practice with a complete valuation model.
The DCF model is very reactive to changes in the terminal value due to its sheer magnitude. The effects of these alterations will be clearly evidenced in the following chapter.