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Terminal Value Calculation in Dcf Valuation Models: an Empirical Verification

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Terminal Value Calculation in Dcf Valuation Models: an Empirical Verification A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Behr, Adam; Mielcarz, Paweł; Osiichuk, Dmytro Article Terminal value calculation in dcf valuation models: An empirical verification e-Finanse: Financial Internet Quarterly Provided in Cooperation with: University of Information Technology and Management, Rzeszów Suggested Citation: Behr, Adam; Mielcarz, Paweł; Osiichuk, Dmytro (2018) : Terminal value calculation in dcf valuation models: An empirical verification, e-Finanse: Financial Internet Quarterly, ISSN 1734-039X, University of Information Technology and Management, Rzeszów, Vol. 14, Iss. 1, pp. 27-38, http://dx.doi.org/10.2478/fiqf-2018-0003 This Version is available at: http://hdl.handle.net/10419/197402 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu Financial Internet Quarterly „e-Finanse” 2018, vol.14/ nr 1, s. 27-38 DOI: 10.2478/fiqf-2018-0003 TERMINAL VALUE CALCULATION IN DCF VALUATION MODELS: AN EMPIRICAL VERIFICATION Adam Behr1, Paweł Mielcarz2, Dmytro Osiichuk3 Abstract The paper presents an empirical verification of the main assumptions underlying the calculation of terminal value in DCF valuation models. The test results suggest that the volatility of free cash flows and the dynamism of the operating environment do not allow us to make a reliable long-term forecast of value creation potential of the public companies in Poland. Regardless of their organic growth phase, the overwhelming majority of the sampled firms are evidenced to exhibit extreme year-on-year fluctuations of sales, investments and cash flows over the short- and medium-term observation windows. The variability of operating results and the probabilistic nature of company- -level fundamentals may preclude the possibility of constructing a reliable cash flow forecast for the purposes of a DCF valuation. This methodological issue appears to pose a particular challenge during the calculation of terminal value, which is heavily dependent on highly subjective and uncer- tain steady-state fundamentals. Therefore, the predictive power of the deterministic DCF models may be reduced to a snapshot of the current market sentiment regarding a particular stock. The paper postulates that a further discussion on the tenets of terminal value calculation may be ne- cessary in order to overcome the existing flaws and increase the accuracy of valuation models. We contribute to this discussion by outlining the principal methodological and theoretical issues which challenge the practicing valuators at the stage of terminal value calculation. Our conclusions may help to shed light on the problems of market short-termism, and high inconstancy of investment recommendations. JEL classification: G17, G32, G38 Keywords: DCF valuation, terminal value, intrinsic value Received: 03.10.2016 Accepted: 10.01.2018 1 Adam Behr, e-mail: [email protected]. 2 Paweł Mielcarz, Koźmiński University, e-mail: [email protected]. 3 Dmytro Osiichuk, Koźmiński University,e-mail: [email protected]. www.e-finanse.com University of Information Technology and Management in Rzeszów 27 Adam Behr, Paweł Mielcarz, Dmytro Osiichuk „e-Finanse” 2018, vol. 14 / nr 1 Terminal value calculation in DCF valuation models: an empirical verification terminal value calculation; thereafter, we present the Introduction findings of an empirical verification of the validity of Along with discounted dividends (Gordon, 1959) and those assumptions; finally, in order to contribute to the residual income models (Lundholm & O’Keefe, 2001), the discussion on possible improvements to the DCF modeling discounted free cash flow (DCF) models constitute the process, we analyze each element of the residual value most frequently applied tool of corporate valuation. Each formula and present our suggestions regarding their of the enumerated types of valuation models relies on appropriate incorporation within the valuation model; a set of rigorous simplifying assumptions, which despite the paper concludes with a discussion of interrelations facilitating the modelling process, may lead to significant between the predictive power of DCF valuation models distortions of the results. and investor short-termism on capital markets. The DCF models have considerably gained in popularity due to enhanced precision and flexibility The Conventional Assumptions (O’Brien, 2003). Estridge and Lougee (2007) explain the Underlying Terminal Value increased recurrence to DCF by the fact that free cash Calculation in DCF Valuation flows (FCF) are less susceptible to manipulation than Models earnings. Damodaran (1994) argues that the after-tax free cash flows generated by the company and distributable Residual (terminal) value predominantly constitutes to both share- and debtholders represent the proper a major part of the total enterprise value, which makes building blocks for corporate valuation models. the accuracy of its calculation an important factor of the Despite its relative simplicity and wide acceptance, overall reliability of a valuation model. The conventional DCF valuation suffers from a number of methodological wisdom presented in corporate finance textbooks (e.g., shortcomings. The issues of particular concern include Copeland et al., 2010; Damodaran, 2010) formulated a the accuracy of corporate free cash flow forecasts (Blanc set of restrictive assumptions, which, if applied correctly, & Setzer, 2015; Jackowicz et al., 2017), the choice of an should constitute a foundation of a sound and accurate appropriate discount rate to calculate the present value of valuation model. However, these assumptions appear to distant cash flows under conditions of uncertainty (Gollier commonly derive from deductive reasoning rather than & Weitzman, 2010; Mielcarz & Mlinarič, 2014), and the from statistical evidence. What is more, the authors assumptions underlying the calculation of terminal value have not found any research studies verifying the validity (Jennergren, 2008). of these assumptions on empirical data. This paper represents an attempt to fill this gap. The paper presents an analysis of the algorithm of terminal value calculation with a particular focus on Copeland et al. (2010) propose the following formula the steady-state forecast period. Relying on empirical for terminal value calculation: evidence, we intend to verify whether the conventional (1) assumptions underlying terminal value calculation are realistic and substantiated. Since the residual value where is the net operating profit after frequently constitutes a major part of the total enterprise taxes in the first year of the post-horizon forecast period; value, an empirical verification of the validity of essential g – the NOPAT growth rate held constant during the entire inputs appears to be crucial for assuring the accuracy of post-horizon forecast period; RONIC – the projected DCF valuation models (Mielcarz & Osiichuk, 2017). Our (implied) rate of return on new invested capital; WACC – empirical results challenge the conventional postulates of the weighted average cost of capital. terminal value calculation and highlight the need for an in-depth discussion of possible built-up valuation models, The standard perpetuity formula for terminal value which would allow us to incorporate the stochastic nature relies on FCF from the last period of the explicit cash flow of the key valuation inputs and to accommodate market forecast (Copeland et al., 2010): dynamics more accurately. (2) The paper is structured as follows: first, we provide where FCFt – free cash flow in year t; other variables a theoretical overview of the assumptions underlying are defined above. www.e-finanse.com 28 University of Information Technology and Management in Rzeszów Adam Behr, Paweł Mielcarz, Dmytro Osiichuk „e-Finanse” 2018, vol. 14 / nr 1 Terminal value calculation in DCF valuation models: an empirical verification In order for the formulae 1 and 2 to yield the same a stabilization of the investment policy and a decrease of result, the perpetuity growth rate (g) should equal: the reinvestment rate. (3) Despite their consistency and straightforwardness, where Reinvestment Rate – the net investments as a the above presented assumptions underlying the residual percentage of NOPAT. value calculation may have some important conceptual shortcomings. For example, the strict criteria of steady Copeland et al. (2010) note that since the terminal growth may preclude the application of the conventional
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