How do you incorporate industry trends and competitive dynamics in cash flow forecasting for terminal value?

1 What is terminal value?

Terminal value is a key component of the discounted cash flow (DCF) method, which is a widely used valuation technique for businesses. DCF calculates the present value of your future cash flows by applying a discount rate that reflects your cost of capital and risk profile. However, cash flow forecasting becomes more uncertain and less reliable as you project further into the future. Therefore, DCF usually assumes a forecast period of five to ten years, and then adds a terminal value that represents the value of your business beyond that period.

2 Why do you need to incorporate industry trends and competitive dynamics?

Industry trends and competitive dynamics are external factors that can have a significant impact on your terminal value. Industry trends include the changes in customer preferences, technology, regulation, and market size that affect the demand and supply of your products or services. Competitive dynamics include the actions and reactions of your current and potential competitors, such as pricing, innovation, differentiation, and entry or exit barriers. These factors can affect your revenue growth rate, operating margin, capital expenditure, and working capital, which are the main drivers of your cash flow and terminal value.

3 How do you incorporate industry trends and competitive dynamics?

There are two common approaches to incorporate industry trends and competitive dynamics in cash flow forecasting for terminal value: the perpetual growth method and the exit multiple method. The perpetual growth method assumes that your cash flow will grow at a constant rate forever, based on your long-term growth potential and industry outlook. The exit multiple method assumes that you will sell your business at the end of the forecast period, based on the market valuation of comparable companies or transactions. Both methods require you to make assumptions and adjustments based on industry trends and competitive dynamics.

4 Perpetual growth method

When calculating the terminal value using the perpetual growth method, you should take into account a perpetual growth rate that reflects your expected long-term growth potential and industry outlook, as well as the sustainability and competitiveness of your business model. Sources of information and analysis such as industry reports, market research, benchmarking, scenario planning, and sensitivity analysis can be used to estimate the perpetual growth rate. It is important to remember that the perpetual growth rate should be lower than the long-term growth rate of the economy and the industry in order to avoid unrealistic assumptions and overvaluation. Additionally, it should be consistent with your discount rate, operating margin, and capital expenditure to ensure a stable cash flow generation and return on investment. Lastly, you should consider the industry life cycle, degree of competition, barriers to entry and exit, innovation and disruption risks, and regulatory and environmental changes that can affect your industry when determining the perpetual growth rate.

5 Exit multiple method

The exit multiple method calculates the terminal value by applying a multiple to a financial metric of the last year of cash flow in the forecast period. This multiple should reflect the market valuation of comparable companies or transactions, taking into account their profitability, growth, risk and size. You can use various sources of information and analysis to estimate the multiple, like industry databases, valuation guides, transaction data, peer group analysis and market multiples. Additionally, you should consider the most relevant financial metric for your industry (e.g. EBITDA, revenue or free cash flow) and adjust for any differences in quality, growth, risk and size between your business and comparables. Moreover, you should account for industry trends and competitive dynamics that could impact the market valuation of your business such as customer loyalty, differentiation, innovation, consolidation and regulation.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?