It depends on how many years we are projecting. In a 5-years DCF, the terminal value (TV) would account for 70 – 80% of the business valuation, and in a 10-years DCF, about 50%.
Let’s take an example. Consider a firm that generates an after-tax operating profit of $100 million. With 25% return on capital (ROC), it reinvests 40% of its earnings back into the business, thereby generating an expected growth rate of 10% for the next 5 years:
Expected growth rate = 25% * 40% = 10%
After Year5, the growth rate is expected to drop to 5%, but ROC to stay at 10%. Terminal value is calculated as follows:
Expected operating income in Year6 = $100 million * (1.10)5 * (1.05) = $169.10 million
Expected reinvestment rate from Year5 = 5% / 25% = 20%
Terminal value in Year5
[$169.10 million * (1 – 0.2)] / (0.10 – 0.05) = $2,705.6 million
Present Value of firm
(44 / 1.10) + (48.4 / 1.102) + (53.24 / 1.103) + (58.56 / 1.104) + (64.42 / 1.105) + ($2,705.6/1.105) = $1,900 million
Now,
$1,900 M / $2,705 M = 70.24%
You may also refer my article on Valuation: Asset Approach, Income Approach and Market Approach here.
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