What is Terminal Value?
Terminal Value (TV) is the estimated present value of a business beyond the explicit forecast period. TV is used in various financial tools such as the Gordon Growth Model, the discounted cash flow, and residual earnings computation. However, it is mostly used in discounted cash flow analyses.
What is the Importance of the Terminal Value?
In financial analysis, the terminal value includes the value of all future cash flows outside of a particular projection period. It captures values that are otherwise difficult to predict using the regular financial model forecast period. There are two methods used to calculate the terminal value, which depends on the type of analysis to be done.
The perpetuity growth model assumes that cash flow values grow at a constant rate ad infinitum. Because of this assumption, the formula for perpetuity with growth can be used. The perpetuity growth model is preferred among academics as there is a mathematical theory behind it. However, it is difficult to agree on the assumptions that will predict an accurate perpetual growth rate.
Terminal Value: Exit Multiple Method
Terminal value is calculated based on what method (discussed previously) the analyst is going to use. Under the exit multiple method, TV is calculated as follows:
TV = Last Twelve Months Exit Multiple x Projected Statistic
The exit multiple can be the enterprise value/EBITDA or enterprise value/EBIT, which are the usual multiples used in financial valuation. The projected statistic, on the other hand, is the relevant statistic projected in the previous year.
Terminal Value: Perpetuity Growth Model
Meanwhile, under the perpetuity growth model, the terminal value is calculated as follows:
TV = (Free Cash Flow x (1 + g)) / (WACC – g)
- Free Cash Flow = FCF for the last twelve months
- WACC = Weighted Average Cost of Capital
- G = Perpetual growth rate (or sustainable growth rate)
Perpetuity growth rate is usually equivalent to the inflation rate and almost always less than the economy’s growth rate. If the growth rate changes, a multiple-stage terminal value can then be determined instead.
What are the Limitations of Using the Terminal Value?
As mentioned previously, the perpetuity growth model is limited by the difficulty of predicting an accurate growth rate. Furthermore, any assumed value in the equation can lead to inaccuracies in the calculated terminal value. On the other hand, the exit multiple method is limited by the dynamic nature of multiples – they change as time passes.
All in all, careful considerations must be in place before applying any of the two methods. But for both methods, using a range of applicable rates and multiples is important in order to get an acceptable valuation result.
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