Telecoms projects DCF and terminal values

The DCF (Discounted Cash Flow) method is one of two ways in which a company or an asset can be valued. The standard practice when using the DCF method is to separate the cash flows in to two periods as follows:

 Total Value =

(Present Value of cash flows during explicit forecast period) +

(Present Value of cash flows after the explicit forecast period)

The first component is the initial growth period. The second (i.e.the Terminal Value) is the value of the company or asset’s expected cash flow beyond the explicit forecast period. Using the Terminal Value concept eliminates the need to forecast in detail the company’s cash flow over an extended period.

As stated in the highly respected and referenced McKinsey text, “Valuation: Measuring and managing the value of companies”[1], the Terminal Value often accounts for a large percentage of the total value of a company or asset.  Figure 1 extracted from p268 of the McKinsey text shows the Terminal Value as a percentage of total value for companies in four industries given an explicit eight year forecast period. As the McKinsey text states,

“Although these continuing values[2] are large, this does not mean that most of the company’s value will be realised in the continuing value period. It often just means that the cash inflow in the early years is offset by outflows for capital spending and working capital investment—investments that should generate higher cash flow in later years.”

Figure 1 Terminal Value as a percentage of total value (Source: McKinsey)

As shown in Figure 1, in High tech industries it is often the case that a large percentage of the value of the company is in the Terminal Value because the early years of the venture requires significant capital spending and working capital investments. In the case of a High tech telecoms venture the rationale for the large Terminal Value component is defensible for the following reasons:

1.       The forecasted cash flow period (typically the initial 10 years) will include several years of negative cash flows whilst the business and subscriber base is established.

2.       Beyond the initial forecast period, the business will have established a significant customer base and brand and will enjoy positive cash flows stemming from this base.

3.       After the initial forecast period, the telecoms business will have established a substantial network, systems and engineering which will have a significant asset value.

[1] “Valuation: Measuring and managing the value of companies” – Third Edition – p267 – McKinsey & Company Inc – Copeland, Koller and Murrin

[2] i.e. the Terminal Value

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