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The case against terminal multiples

Jamie BallingallJamie Ballingall
“Essentially, all models are wrong, but some are useful” George E. P. Box, British mathematician, and Professor of Statistics

Any valuation text will tell you about the two different approaches to estimating the terminal value for a discounted cashflow valuation:

The perpetuity growth method:

You pull a long-term growth rate out of the air, assume that free cash flows grow at that rate forever and discount back.

Exit multiple:

You pull a future valuation multiple out of the air, assume that the business is sold on that valuation at the terminal time and discount back.

When reading discussions about these two approaches, you will likely encounter a balanced thoughtful discussion of the circumstances of when to use one over the other, usually ending with a suggestion to do both.

I’m here to say don’t bother. The exit multiple method is pointless and should never be used.

Nobody builds a DCF model in isolation—it’s always presented next to a multiples analysis. Usually, there are Last Twelve Month multiples and Next Twelve Month multiples. A DCF with an exit multiple is just a Next Five Years multiple analysis—just more of the same.

A DCF with a perpetuity growth terminal value may or may not be more accurate. But it definitely provides more information because it doesn’t just repeat a separate, easier to understand model.

In reality, both models are wrong. But one is more useful than the other. The more useful one wins.

Any thoughts on the flaws of modeling? Email me at jamie@pellucid.com.

P.S. My colleague Eric Rattner points out an additional advantage to perpetuity growth. It encourages you to think about how many periods you should be explicitly modeling. Often people use round numbers like 10 years and then go to a terminal value. A smart practitioner wants to explicitly model all the “interesting” periods—any period where your firm is not just in a steady state and only take a terminal value once sales growth has moderated and all the competitive pressures on margins have reached an equilibrium.

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Chief Scientist & Co-Founder at Pellucid Analytics. Former Wall St. strategist & quant and Columbia University adjunct professor. Solving complicated technical and mathematical problems.

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