Value Driver formula for Terminal Value. When calculating terminal value using a traditional growth perpetuity, we usually use the final year's free cash flow forecast, and apply a long-term growth rate and the cost of capital to that. However, an alternative approach is to use the value driver formula. Now, to understand this approach, we need to remind ourselves of the link between NOPAT and free cash flow. So let's start with an example company. This is a company that has $1,000 of invested capital at the start of 2OX1. Now, an analyst has forecast the following For 2OX1. There's NOPAT of 200, depreciation of 100, CapEx of 110, and a change or an increase in working capital of 50. And that gives the analyst a free cash flow forecast of 140. Now, it's important to remember that Capex less depreciation is the net increase in PP&E. So PP&E must have increased by 10 during the year. But also the change in working capital of 50 means that net operating working capital in the balance sheet must have increased by 50. So this means that the total operating assets, that's the invested capital of the business, must have increased by 60 in the year. So we can describe this 60 as the net reinvestment in the business. Free cash flow is therefore equal to NOPAT less net reinvestment. And this is a really important relationship, as it reminds us that if a company wants to grow, the growth will come from reinvestment of profits. Growth isn't free. Now, if the invested capital of the company has increased by 60 and opening invested capital was 1000, then this represents a growth rate in the invested capital of 6%. We can then rearrange this to say that net reinvestment of 60 is equal to the growth rate of the company of 6% multiplied by opening invested capital of 1000. Now this is really helpful, 'cause if we know free cash flow is NOPAT less net reinvestment, that means that free cash flow is NOPAT less the growth rate times by invested capital. This means that we can take the traditional terminal value formula, which is shown on the screen here, and we can substitute free cash flow

However, we also know that return on invested capital is NOPAT divided by invested capital. So when we put both of these into the terminal value formula, this shows us a new way of calculating terminal value. And this terminal value formula is described as the value driver formula, and it's a really useful way of calculating terminal value, as it requires an explicit link between profitability, that's NOPAT, growth, and return on invested capital. In fact, one of the most common errors when using the traditional terminal value formula in DCF is that an analyst will forecast a really high growth rate, but the free cash flow forecasts in a terminal year use a reinvestment rate that's not sufficient to support that high growth rate. But you can't see this when you're using the traditional formula, and the result is that you have a really high terminal value, but that's based on inappropriate assumptions. If instead we use the value driver formula, we're forced to make an assumption about long-term growth and the return on invested capital of the business. So if an analyst forecasts a really high growth rate, but the company has a low return on invested capital, then the value driver formula will automatically reflect the fact that this high growth requires a really large amount of reinvestment, and the result is that you have a lower terminal value based on more appropriate assumptions.