Terminal Value

The predicted value of companies or assets by a certain time in the future is known as the terminal value. Calculating the present value of future cash flows is usually completed through the process of discounted cash flow analysis.

This value can be calculated using the perpetual growth method and exit multiple method.

According to the perpetual growth technique, an asset or company will always expand at a constant rate. The Gordon growth model is the foundation of this approach.

In this approach, the value of a company can be calculated by the following formula. First, find the difference between the needed rate of return and the growth rate. Then divide the expected dividend yield by that number.

In the perpetual growth method, the company is assumed to continue growing at a constant rate indefinitely. This is not always accurate for long term calculations because the accuracy of the estimate will decline with time.

Nonetheless, it is still useful for evaluating companies in shorter time frames.

What is Terminal Value?

Terminal value is the present value of all future cash flows that a business or an investment is expected to generate beyond a certain forecast period. It is often used to gauge the value of a company with an indefinite life span.

For example, consider someone wanting to value a company that will continue operating for the foreseeable future. 

They cannot project their cash flows for every year until infinity. Instead, they can use this value to capture the value of all the cash flows beyond a certain point, such as 10 years from now.

There are two main approaches to calculating this value: 

1. The perpetual growth method 
2. The exit multiple methods 

The perpetual growth method assumes that the cash flows of the business or the investment will grow at a constant rate forever. Typically, this rate is lower than the economy's or an industry's long-term growth rate.

The exit multiple method is more flexible and market-based, but it requires more data and analysis to determine the appropriate multiple, which may not be available or reliable. This value is a crucial element in valuation techniques like discounted cash flow and economic value added.

These methods use this value to account for a business's or an investment's residual value after subtracting its initial cost and operating cash flows over a certain period. 

Particularly if the prediction period is brief or the discount rate is large, this number may considerably impact the final valuation outcome. 

Therefore, it is essential to use reasonable assumptions and methods to estimate this value and to perform sensitivity analysis to test how different scenarios affect it.

Terminal Value Formula

The purpose of the following formula is to calculate a final value for a company’s worth at the end of a period of time.

The formula using the perpetual growth method is:

Terminal value = FCFn * (1 + g) / (r - g)

Where

• FCFn is the free cash flow in the last forecast year
• g is the perpetual growth rate
• r is the discount rate.

The exit multiple approach assumes that the item or business will be sold for a particular multiple of its earnings or the value of its cash flow at a certain point in time.

The formula using the exit multiple methods is:

Terminal value = EBITDA * EV/EBITDA

Where 

• EBITDA is the earnings before interest, taxes, depreciation, and amortization in the last forecast year. 
• EV/EBITDA is the enterprise value to EBITDA multiple of comparable companies or transactions.

Because it can be worth a lot of money in the valuation of a business, this value is meaningful. By way of illustration, if an analyst projects cash flows for ten years and applies a discount rate of ten percent, this value will account for around 39% of the total present value.

However, this value also involves a lot of uncertainty and subjectivity, as it depends on the assumptions about future growth rates, exit multiples, and discount rates. 

These assumptions may not reflect reality or may change over time. Therefore, this value should be used cautiously, and sensitivity analysis should be performed to test how different assumptions affect the valuation outcome.

How to calculate the terminal value in DCF

Terminal value is the estimated value of a business or project beyond the forecast period, usually three to five years. It is a critical part of the discounted cash flow model.

The model is a popular valuation technique that projects the future cash flows of a business and discounts them to the present value.

This value often accounts for a large percentage of the total value of a business or project, especially for mature or stable companies that have predictable cash flows. 

Without this value, the DCF model would only capture the value of a business for a limited time, which may not reflect its true potential. This value also helps to avoid the uncertainty and inaccuracy of forecasting cash flows far into the future.

The perpetual growth approach and the exit multiple methods are the two basic ways to determine this value.

The exit multiple approach assumes that a company will be sold after the forecast period for a multiple of some market indicator.

The perpetual growth method uses the following formula to calculate this value:

Terminal Value = Final Year FCF * (1 + Perpetuity Growth Rate) / (Discount Rate - Perpetuity Growth Rate)

In this formula, FCF stands for free cash flow, which is the cash flow available to investors after deducting capital expenditures and working capital changes. 

The perpetuity growth rate is the expected annual growth rate of FCF in perpetuity, which should be lower than the economy's long-term growth rate.

For example, suppose Apple Inc. has an FCF of $100 million in year 5, which is the final year of the forecast period. The perpetuity growth rate is assumed to be 2%, and the discount rate is 10%. This value using the perpetual growth method would be:

Terminal Value = 100 * (1 + 0.02) / (0.1 - 0.02) = $1,224 million

The exit multiple methods uses the following formula to calculate the same value:

Terminal Value = Final Year Metric * Exit Multiple

In this formula, the final year metric can be any market-based measure that reflects the value of a business. For example, it can be revenue, earnings before interest and taxes, EBITDA, or net income.

Exit multiple is the ratio of enterprise value to metric, representing how much an acquirer would pay for a business based on its performance.

For example, consider a company with an EBITDA of $150 million in the fifth year. The forecast period is five years. The exit multiple is assumed to be 8x, meaning an acquirer would pay 8 times EBITDA for the company. 

The same value using the exit multiple methods would be:

Terminal Value = 150 * 8 = $1,200 million

Calculating Terminal Value using the Exit Multiple Method

The exit multiple technique assumes that the business will be sold after the projection period, with its worth determined by the market value of similar businesses.

To use the exit multiple methods, you need to follow these steps:

1. Choose an appropriate multiple

Choose a multiple such as EBITDA, revenue, or earnings. The multiple should reflect the company's and industry's profitability, growth potential, and risk profile.

2. Find comparable companies

Find companies that operate in the same industry and have similar characteristics as the company being valued. You can use public market data or transaction data to find the multiples of these companies.

3. Calculate the average 

 You can also adjust the multiple for any differences in size, growth, margins, or risk between the comparable companies and the valued company.

4. Find the terminal value

Multiply the last projected cash flow of the company by the multiple to get the terminal value. 

For example, if you use an EBITDA multiple and project that the company will have an EBITDA of $100 million in year 5, and the average EBITDA multiple of comparable companies is 10x, then this value is $100 million x 10x = $1 billion.

5. Discount to present value

Discount this value to the present value using the weighted average cost of capital (WACC) or another appropriate discount rate.

The exit multiple methods has some advantages over the perpetuity method, such as:

• It is more realistic and flexible, reflecting the market expectations and valuation multiples of comparable companies. It also allows for different exit scenarios and exit dates.
• It is more consistent and comparable, using market-based data rather than subjective assumptions about growth rates and margins.

The exit multiple methods also has some drawbacks, such as:

• It is more difficult and subjective, requiring finding and selecting appropriate multiples and comparable companies. It also involves adjusting for differences in size, growth, margins, or risk.
• It is more uncertain and volatile, depending on market conditions and sentiments that may change over time or vary across different sectors.

Different exit multiples have different strengths and weaknesses depending on the industry or sector of the company being valued. For example:

• EBITDA multiple is widely used for mature and stable companies with consistent cash flows and margins, such as utilities, telecoms, or consumer staples.
• It may not be suitable for high-growth or low-margin companies like technology or biotech.
• Revenue multiple is often used for high-growth or low-margin companies with strong revenue potential but not profitable or have negative cash flows.
• It may not be suitable for companies with stable revenue but declining growth.
• Earnings multiple is usually used for profitable and growing companies with positive cash flows and earnings, such as consumer discretionary.

Therefore, when choosing an exit multiple for a company, you should consider:

• The industry characteristics and trends
• The company's growth potential and profitability
• The availability and reliability of market data
• The consistency and comparability of multiple

Calculating Terminal Value using the Perpetuity Growth Model

The perpetual growth method is built on the presumption that the cash flows of a business or a project will rise at a constant rate indefinitely.

This implies that the business or the project has reached a steady state and will not experience any significant changes in its operations, competitive environment, or market conditions.

The perpetual growth rate is typically gauged from the expected long-term economic, industry, or inflation growth rate. 

Since, by definition, the perpetual growth model is based on the unlimited expansion of this firm for eternity, the growth rate must be lower than the growth rate of the broader country’s economy. 

If the company's growth rate was larger, it would eventually grow to exceed the value of everything else. This is not plausible because it would then own everything.

WACC stands for the Weighted Average Cost of Capital. The discount rate reflects the risk and opportunity cost of investing in the business or the project. This value can be found by finding the average of all the costs of capital. This includes the cost of equity and the cost of debt.

The two costs are averaged together with assigned weightings to each input.

This value calculated using the perpetual growth method is adjusted to the present value through a predetermined discount rate. For example, the WACC.

The present value of this value is then added to the present value of the cash flows during the forecast period to obtain the total value of the business or the project.

Perpetual growth terminal value assumes that a business operates forever and continues to produce profits.

Here are the benefits when using the Perpetuity Growth Model:

• It is simple and easy to apply with few inputs and assumptions.
• It is consistent with the theory of discounted cash flow valuation. This is because it states that a company is worth as much as the value of all future cash flows discounted to the value of present-day money.
• It is widely used and accepted by academics and practitioners due to its solid mathematical foundation.

The drawbacks of the Perpetuity Growth Model:

• It is sensitive to the assumptions of the growth rate and the discount rate, as small changes in these inputs can greatly impact the terminal value.
• It presumes that a business would expand at a constant rate indefinitely, which is improbable in a dynamic and competitive market.
• It may overestimate or underestimate the value of a business. This is because it ignores the potential changes in the industry structure, competitive advantage, and profitability.

Researched and authored by Haimeng Yang | LinkedIn

Reviewed and edited by Naveeth Rishwan Habeeb | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Adjusted Present Value (APV)
• Discounted Cash Flow (DCF)
• EV/EBIT Ratio
• EV/EBITDA
• Net Present Value (NPV)