When valuing a business using the discounted cash flow method, residual (or terminal) value is a key component. The International Valuation Glossary — Business Valuation defines residual value as “the value as of the end of the discrete projection period in a discounted future earnings model.”

Business valuation experts typically consider the capitalization of earnings method and the market approach when estimating residual value. Either (or both) may be appropriate, depending on the nature of the business, purpose of the valuation, reliability of the company’s financial projections and availability of market data.

Capitalizing earnings

The capitalization of earnings method is based on the assumption that cash flow will stabilize in the final year of the projection period. However, this is also the time period that’s subject to the greatest margin for error because it’s the furthest into the future.

Under the capitalization of earnings method, residual value equals expected future cash flow (the numerator) divided by a capitalization rate (the denominator). The long-term sustainable growth rate is used in the numerator to determine cash flow in the final projection period. Then it’s used again in the denominator because the capitalization rate equals the discount rate minus this growth rate.

Because it’s in both the numerator and the denominator, the long-term sustainable growth rate can have a significant effect on residual value. A minor change in this rate can have a major impact on business value.

Applying the market approach

Another way to estimate residual value is to assume that the business could theoretically be sold at the end of the discrete period in an arm’s length transaction. Using the market approach, a business valuation expert considers comparable public stock prices and sales of comparable private businesses. Although the market approach sounds straightforward, it can sometimes be difficult to find comparable transactions, especially for small private companies.

Comparable market data also might serve as a sanity check. For example, a valuation expert might compare:

• The implied pricing multiples from a residual value that’s been calculated using the capitalization of earnings method, and

• Average pricing multiples from comparable transactions involving similar companies in recent years.

There may be cause for concern if, say, a company’s residual value generates a price-to-revenue multiple of 5.0 and comparable transactions during the last 12 months indicate an average price-to-revenue multiple of 1.2. The expert would need to explain the reason for such a discrepancy — or possibly adjust his or her analysis.

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Residual value can be a major part of the valuation puzzle, so it’s important to get it right. Like annual cash flows over the discrete projection period, residual value is discounted to present value to arrive at the value of a business under the discounted cash flow method.

(This is Blog Post #1242)