Terminal Value

Valuing a stock involves assuming that its growth rate will slow down to a long-term rate comparable to the economy. The value projected at the end of the high-growth stages based on the long-term growth rate is known as the terminal value of the stock (or continuing value).

The terminal value may be calculated :

1. Using the Gordon growth model.
2. Applying a multiple, e.g., P/E to an estimated fundamental, e.g., EPS at the terminal date.

Example: Estimating Terminal Value using the Gordon Growth Model and a P/E Multiple

Consider the following information:

• Recently paid annual dividend = $0.40.
• Dividend growth rate = 12% for the next 5 years.
• The growth rate will stabilize to a long-term rate of 4%.
• Trailing P/E ratio at the end of the initial high-growth period = 6.
• Retention ratio = 25%.
• Required rate of return = 12%.

Using the Gordon growth model, the terminal value is calculated as:

$$\begin{align*}\text{Year 5 dividends}&=0.40(1.12)^{5}\\&=0.70\\ \\ \text{Terminal value}&=\frac{0.70(1.04)}{12\%-4\%}\\&=\frac{0.728}{0.08}\\&=9.16\end{align*}$$

Using a P/E multiple, the terminal value is calculated as:

$$\begin{align*}\text{Year 5 dividends}&=0.70\\ \\ \text{Year 5 EPS}&=\frac{0.70}{0.25}=2.8\end{align*}$$

Applying the trailing P/E of 6 based on year 5 EPS of 2.8, the terminal value is:

$$\text{V}_{0}=2.8\times6=16.8$$

Question

A company’s current EPS of $2.50 is expected to grow at 12% for 8 years. After that, it will decline to a long-term rate of 4%. If the trailing P/E at the end of the high growth stage is 9, the terminal value is closest to:

1. $22.55.
2. $57.80.
3. $55.70.

 Solution

The correct answer is C.

$$\begin{align*}\text{EPS}_{8}&=2.50(1.12)^{8}=6.19\\ \\ \text{Terminal value}&=6.19\times9=55.71\end{align*}$$

Reading 23: Discounted Dividend Valuation

LOS 23 (k) Describe the terminal value and explain alternative approaches to determining the terminal value in a DDM.