Case 071DCF and intrinsic valueCore

An analyst's DCF of Olvan Consumer uses 6% perpetual growth against a 9% WACC, and the terminal value is 85% of the total. What exit multiple does that terminal value imply, and how would you fix the model?

The situation

A junior analyst hands you a DCF of Olvan Consumer, a packaged foods company. The model discounts five years of free cash flow at a 9% WACC and then applies a perpetual growth rate of 6% to year-5 free cash flow of Rs 100 crore. Year-5 EBITDA is Rs 160 crore. The terminal value is 85% of the enterprise value.

Listed packaged foods peers trade at about 14x EBITDA. You have ten minutes before the model goes to the director.

Your task

Work out the exit multiple the terminal value implies, explain why it is where it is, and say how you would fix the model.

Quick check

Growth is 6% and the WACC is 9%. If the analyst had used 5% growth instead, roughly how much would the terminal value fall?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The terminal value is Rs 3,533 crore, 22.1x year-5 EBITDA, against peers at 14x. Rs 100 crore grown 6% and divided by 9% less 6% gives Rs 3,533 crore. The multiple is high because the gap between WACC and growth is only three points. Fix it by cutting growth to a rate the business can earn, about 4.3% matches the peer multiple, which lowers enterprise value from Rs 2,702 crore to about Rs 1,861 crore, 31% less.

Step 1How do you read the exit multiple out of a perpetuity?

Suppose a shop rents for Rs 1 lakh a year and you are told it is worth Rs 50 lakh: that is 50 years of rent, and your reaction is to ask what the shop next door sold for. Every perpetual growth terminal value is also a multiple of year-5 earnings; dividing one by the other is the sanity check, and it takes one line. Olvan's terminal value is Rs 100 crore times 1.06 divided by (0.09 less 0.06), Rs 3,533 crore. Divided by year-5 EBITDA of Rs 160 crore, that is 22.1x. The peers trade at 14x today, for a business at the same stage; the model is saying that in five years a buyer will pay more than half as much again per rupee of EBITDA.

The relationship

TV = \frac{FCF_5 (1+g)}{WACC - g} = \frac{100 \times 1.06}{0.09 - 0.06} = 3,533 \qquad \frac{TV}{EBITDA_5} = \frac{3,533}{160} = 22.1\times

FCF_5	free cash flow in the final forecast year, Rs crore
g	perpetual growth rate after year 5
WACC	weighted average cost of capital, the discount rate

What it says in wordsThe terminal value is next year's cash flow divided by the gap between the discount rate and growth; dividing it by year-5 EBITDA turns it into a multiple you can compare with the market.

Olvan's terminal value at 6% growth is 22.1x year-5 EBITDA, well above the 14x its peers trade at, and the model would only match the peers at a growth rate of about 4.3%.

Step 2Why is the multiple so high, and what growth rate would be defensible?

The culprit is the denominator. WACC less growth is 3 points, and the terminal value is inversely proportional to it, so every point of growth changes value by a third or more. At 5% growth the terminal value is Rs 2,625 crore and the implied multiple 16.4x; at 4% it is Rs 2,080 crore and 13.0x; at 3%, Rs 1,717 crore and 10.7x. Working backwards, the growth rate at which the model matches the peers' 14x is 4.3%: that is the rate the market is implicitly paying for, and the analyst's 6% is a claim that Olvan grows faster than the economy forever, which no packaged foods company does.

Perpetual growth	Terminal value, Rs crore	Implied EV / EBITDA
3%	1,717	10.7x
4%	2,080	13.0x
5%	2,625	16.4x
6%	3,533	22.1x
7%	5,350	33.4x

At a 9% WACC the implied multiple rises from 10.7x at 3% growth to 33.4x at 7%, and the peers' 14x corresponds to growth of about 4.3%.

The implied exit multiple climbs from 9.1x at 2% growth to 33.4x at 7% and steepens as growth approaches the 9% WACC, crossing the peers' 14x at 4.3% growth and reaching 22.1x at the analyst's 6%.

Step 3How would you fix the model before it goes upstairs?

Three changes, in order. First, cut the growth rate to something the business can earn: 4.3% or lower, and no higher than long-run nominal growth in the economy. Second, cross-check with an exit multiple: at 14x the terminal value is Rs 2,240 crore, discounted to Rs 1,456 crore, so enterprise value falls from Rs 2,702 crore to Rs 1,861 crore, 31% lower, with the terminal value 78% of the total instead of 85%. Third, make growth cost something: a company growing 6% at a 15% return on capital has to reinvest 40% of its after-tax operating profit, and the model's free cash flow at 62% of EBITDA leaves no room for that. Free cash flow and growth were set independently, which is how the model got here.

Say the limitation too. The peers' 14x is today's multiple, not year 5's, so matching it exactly is also an assumption, and a terminal value that is 78% of the total is still most of the answer. The honest output is a range: growth from 3% to 4.3% and exit multiples from 12x to 14x, presented as a grid, with the analyst's 6% shown as the corner it is.

Where candidates lose it

Candidates compute the terminal value and stop, without converting it to a multiple. The implied 22.1x is the number that makes the problem obvious to a director in one glance, and it is one division away.

The second slip is proposing to raise the WACC to compensate. That hides the error inside a different assumption; the fix is the growth rate, with free cash flow made consistent with it.

What the interviewer asks next

The director says 6% is fine because the company grew 9% last year. How do you answer?
At 4% growth and a 9% WACC, how much reinvestment does the free cash flow need to support, and does Rs 100 crore allow it?
How would you present the valuation as a sensitivity grid, and which cell would you highlight?

Company names and figures are illustrative.

1The situation

2Your task