The annual EACVA valuation conference (www.bewerterkonferenz.de ) took place in Düsseldorf on 22–23 November 2018. It is the industry gathering for anyone involved in business valuation. Approximately 350 participants attended presentations on succession, fairness opinions, distressed valuation and start-up valuation. My own presentation addressed terminal value and the associated practical challenges.
Many valuers still rely on ready-made models for terminal value, the phase following a detailed forecast of five to ten years. Examples include the value-driver model, which derives long-term value contributions from accounting returns and earnings payout ratios, and the Bradley–Jarrell model, which uses economic returns and cash flow payout ratios. I was once a strong advocate of the latter, as discussed at Valuesque, and retain some appreciation for it.
Both models have nevertheless lost considerable explanatory power in today’s business environment. First, accounting is increasingly unable to represent economic developments adequately because modern businesses rely heavily on intangible assets absent from the balance sheet, such as employees’ knowledge and creativity or internally developed capabilities. Second, fundamental analysis has advanced to the point where such auxiliary models may no longer be necessary. They can even be harmful by obscuring rather than explaining actual operating performance. Third, these models divide business activity into a base component and a growth component with different performance characteristics. That distinction is rarely fully appropriate for valuation and often represents the company’s reality poorly.
I also discussed problems relating to terminal value itself, rather than to particular models. These included unjustified explicit adjustments for insolvency probabilities within terminal value and the frequently observed inconsistency between project returns and the returns assumed in the terminal phase.
The conclusion is that simple growth models, carefully calibrated through fundamental analysis, are often preferable to forcing a company’s expected future into economically unsuitable frameworks. This also provides a more transparent way to address common disputes in M&A and succession transactions, where sellers see enormous potential in terminal value while buyers would prefer to exclude it entirely.