What action should be taken if a terminal FCF growth rate appears too high when using terminal multiples?

What action should be taken if a terminal FCF growth rate appears too high when using terminal multiples?

• A. Ignore it and proceed with calculations
• B. Reduce the terminal multiple or growth rate
• C. Increase other financial metrics to balance
• D. Consult with financial advisors for confirmation

Answer: (B)

When evaluating terminal values in a discounted cash flow analysis, setting a terminal free cash flow (FCF) growth rate that is overly optimistic can distort the valuation significantly. It is essential to ensure this growth rate aligns with long-term economic fundamentals, such as GDP growth rates, industry averages, and company-specific growth opportunities. If the terminal FCF growth rate seems excessively high, it is prudent to adjust either the terminal multiple or the growth rate. Reducing the terminal multiple or growth rate ensures that the assumptions you’re working with remain grounded in reality and reflect conservative, sustainable performance expectations. High growth assumptions, especially in perpetuity, may lead to inflated terminal values that don’t accurately represent the firm’s expected future cash flows. This adjustment helps to provide a more realistic and responsible valuation, maintaining the integrity of the DCF model and ultimately leading to a more accurate financial analysis and decision-making process.

When evaluating terminal values in a discounted cash flow analysis, setting a terminal free cash flow (FCF) growth rate that is overly optimistic can distort the valuation significantly. It is essential to ensure this growth rate aligns with long-term economic fundamentals, such as GDP growth rates, industry averages, and company-specific growth opportunities.

If the terminal FCF growth rate seems excessively high, it is prudent to adjust either the terminal multiple or the growth rate. Reducing the terminal multiple or growth rate ensures that the assumptions you’re working with remain grounded in reality and reflect conservative, sustainable performance expectations. High growth assumptions, especially in perpetuity, may lead to inflated terminal values that don’t accurately represent the firm’s expected future cash flows.

This adjustment helps to provide a more realistic and responsible valuation, maintaining the integrity of the DCF model and ultimately leading to a more accurate financial analysis and decision-making process.