What is Terminal Value?
Terminal value is the estimated value of all future cash flows generated by a business or asset in the aftermath of the traditional forecasting period.
Most asset valuation calculations measure the present (or discounted) value of future cash flows; however, it is extremely difficult to forecast beyond a set number of years due to uncertainty.
he TV method is a way to simplify the calculation of what cash flows are worth beyond the forecastable period.
Calculating Terminal Value
There are two widely accepted methods used to calculate the terminal value of an asset: the perpetuity growth method and the exit multiple method.
The Perpetuity Growth Method
The perpetuity growth method calculates the terminal value by assuming a company will grow its free cash flow at a consistent rate in the future.
In other words, this method assumes a company will continue to grow at a predictable rate (on average) indefinitely and calculates the value of that cash flow profile.
To use this method to calculate terminal value, you must have an estimate for free cash flow at the terminal point, at a discount rate, and at a perpetual growth rate.
Free cash flow at the terminal point is simply the free cash flow one year after the last year in the forecast period of a valuation analysis. The discount rate is the required rate of return that converts the future value of money to the present value.
The perpetual growth rate is the rate at which an asset can sustainably grow (on average) over a very long time horizon. For mature businesses, it makes sense to use an industry average growth rate or a number close to long-term average GDP growth for the perpetual growth rate input.
The formula below illustrates the perpetual growth method calculation.
The Exit Multiple Method
The exit multiple method calculates the terminal value by estimating a fair sales price the asset could be sold for, which is usually expressed by a multiple of earnings or cash flow.
For example, in an industry where businesses are sold for ten times cash flow, an analyst can calculate the terminal value by assuming the business is sold for ten times terminal year cash flow.
Terminal Value and Discounted Cash Flow Analysis
The terminal value is most commonly used as part of the discounted cash flow analysis (DCF).
A discounted cash flow analysis values a business or asset by calculating the present value of estimated future cash flows. As mentioned earlier, an analyst can only reasonably forecast future cash flows five to ten years out (depending on the information available).
However, a business has value beyond ten years in the future, and the terminal value calculation is used to estimate that value.
In the DCF analysis, the terminal value is calculated using either the perpetuity growth method or the exit multiple method in the year following the last business forecast.
For the terminal value to be meaningful it must be discounted to the present using a discount rate. The terminal value is added to the present value of an asset’s cash flows in the years preceding it to calculate the total present value.
The image below diagrams the process of running a DCF analysis, including where the terminal value comes into play.