Terminal value (TV) represents the value of an asset, business, or project beyond the forecasted period when future cash flows can be predicted. Terminal value presumes continued business growth at a predetermined rate infinitely beyond the forecast period. It often constitutes a major portion of the overall assessed value.
Key Takeaways
- Terminal value (TV) determines a company’s value into perpetuity beyond a forecast period.
- Analysts use the discounted cash flow model (DCF) to calculate the total value of a business. Both the forecast period and the terminal value are integral components of DCF.
- The most common methods for calculating terminal value are the perpetual growth (Gordon Growth Model) and exit multiple.
- The perpetual growth method assumes ongoing cash flows at a consistent rate, while exit multiple presumes the business will be sold.
Understanding Terminal Value
Forecasting becomes progressively uncertain as the time horizon extends. This challenge is paramount in finance, particularly when estimating a company’s long-term cash flows. Yet, businesses need valuations. To tackle this, analysts use financial models, like discounted cash flow (DCF), incorporating assumptions to derive the total value of a business or project.
The DCF method is popular in feasibility studies, corporate acquisitions, and stock market valuation. It operates on the principle that an asset’s value is the sum of all future cash flows discounted to their present value using a rate representing the cost of capital.
Forecast Period and Terminal Value
DCF has two major components: the forecast period and terminal value. Analysts usually consider a forecast period of three to five years to maintain accuracy in projections, though this can vary by industry.
Two prevalent methods to calculate terminal value are perpetual growth and exit multiple. The perpetual growth method assumes perpetual, constant-rate cash flow generation, while the exit multiple method assumes eventual business sale at a market-value multiple. Investment professionals often prefer the exit multiple method, whereas academics typically endorse the perpetual growth model.
How Is Terminal Value Estimated?
Several terminal value formulas exist, projecting future cash flows to yield a present value. The liquidation value model (or exit method) involves determining the asset’s earning power with an appropriate discount rate and adjusting for outstanding debt.
In contrast, the stable (perpetuity) growth model assumes continuous operation post-terminal year, reinvesting cash flows to grow at a consistent rate forever. The multiples approach uses the final year’s sales revenue in the DCF model, multiplying a chosen market metric without extra discounting.
The perpetuity growth model formula, devised by economist Myron Gordon, is:
FCF / (d − g)
Where:
- FCF = free cash flow for the last forecast period
- g = terminal growth rate
- d = discount rate (often the weighted average cost of capital)
The terminal growth rate aligns with the long-term inflation rate, without exceeding historical GDP growth rates.
Perpetuity Method
Due to the time value of money, forecasting precise long-term performance of ongoing businesses can be complex. Investors can surmount this by assuming stable cash flow growth ad infinitum, encapsulated as terminal value.
Exit Multiple Method
Where perpetual growth isn’t assumed, terminal value can reflect a company’s net realizable asset value, often based on acquisition metrics. These metrics include sales, profits, or EBITDA, assessed relative to recently acquired analogs.
Notably, terminal value forms a substantial segment of a business’s DCF model, representing the value of all post-forecast-period cash flows, making the assumptions surrounding terminal value crucial.
Terminal Value vs. Net Present Value
Terminal value is not synonymous with Net Present Value (NPV). TV determines an asset’s end-of-period value, while NPV gauges investment or project profitability through discounted future cash flows minus initial investment. NPV aids in deciding the attractiveness and return potential of investments.
Why Terminal Value Is Crucial
Companies generally operate with indefinite timelines. Terminal value elucidates future business value, reflected in present-day pricing through discounting.
Which Model To Choose: Perpetuity Growth or Exit Approach?
Neither DCF analysis model will perfectly estimate terminal value. Perpetual growth estimates are inherently optimistic, while exit multiples offer conservative valuations. Combining both into an averaged terminal value can yield balanced estimates.
Negative Terminal Value - What Does It Mean?
A negative terminal value arises if future capital costs exceed growth assumptions, yet such scenarios are transient. Practically, firm equity can only reduce to zero, handled in bankruptcy proceedings. Negative NPV scenarios call for alternate fundamental valuation tools.
The Bottom Line
Terminal value is essential for estimating asset value post-forecast period. A fundamental element of DCF analysis, TV demands careful assumption consideration due to its substantial impact on business valuation calculations.
Related Terms: Net Present Value, Perpetuity Growth, Exit Multiple, Business Valuation
References
- PwC. “4.4 Valuation Approaches, Techniques, and Methods”.
- New York University, Leonard N. Stern School of Business. “Estimating Terminal Value (Aswath Damodaran)”.
- The Review of Economics and Statistics via JSTOR. “Dividends, Earnings, and Stock Prices”.
