Terminal Value

Meaning of Terminal Value

Terminal Value is the present value of all future cash flows of a business or a project with an assumption of a stable growth rate in the future. It is calculated for a future point in time, with the valuation of cash flows beyond the projection period of several years. It is also known as “Continuing value” or “horizon value.” The terminal value concept is mostly used in discounted cash flow analysis (DCF).

Discounted cash flow analysis is a popular method for valuation at the time of corporate acquisitions, conducting feasibility studies, and also for stock market valuations. The future cash flows form the basis for the valuation of a company or a project in this analysis. These cash flows are taken for a few years only; otherwise, the results may be inaccurate. After this, the calculation of terminal value becomes useful and essential. The value of the company’s assets or the approximate value of the future expected cash flows is used as the terminal value. Then the discounted cash flow analysis is done to find the present value.

Methods of calculating the terminal value

There are two different methods for the calculation of the terminal value.

Perpetuity growth model

The underlying assumption under this model is that the business will go on functioning till perpetuity. It will keep growing at a stable rate forever and hence, keep generating cash flows. Also, it assumes that the cash flows of the last year were stable, and the return on capital is higher than the cost of capital. It then discounts them at the weighted average cost of capital to find the present value of the probable future cash flows.
The formula for calculation of terminal value under this method is:
{FCF * (1+g)}/ (d-g)
Here, FCF= Free cash flow for the last forecast period
g= Terminal growth rate or the rate at which the company is expected to grow forever. It is usually equivalent to the rate of inflation but lesser than the growth rate of the economy.
d= weighted average cost of capital or the discount rate

Example

Let us suppose that a project has to be valued. The given values are:

  • The terminal growth rate or the constant rate  – 3%.
  • The weighted average cost of capital is – 12%.
  • The free cash flow after six years is estimated – US$ 21 million.

Hence, the Terminal value of the project is:
{21 * (1+.03)}/(.12-.03)
=(21*1.03)/ .09
=21.63/.09
=240.33
Therefore, the present worth of the project is US$ 240.33 million.
Terminal Value

Terminal or exit multiple methods

This method is the standard of use in case of a project or a business with a finite life. In such cases, the perpetuity growth model is not of use. Instead, the net realizable value of assets at that very point of time is calculated with the help of terminal value. This value can be of use in case of acquisitions by some other company by using exit multiples such as EBITDA or EBIT. Also, these multiples can be of use as an average over a period in case of cyclical businesses.
The formula for calculation of Terminal value using this method is:
TV= Last twelve months exit multiplex Projected statistic.
We have to search for an appropriate multiple by comparing it with data from similar companies. In a case related companies are trading at 8x their EBITDA or EBIT, we can use the same figure for our company with the assumption that our company will also trade in that range in the future. It will give us the future value at the end of year x. The net present worth will have to be then calculated of the terminal value as well as that of the free cash flows to arrive at implied enterprise value. This calculation can be further of use to arrive at the correct share price of a company.

Limitations of Terminal Value

  • The growth rate and the discount rate are assumptions in the perpetuity growth model. Any inaccuracy in these rates can lead to improper results. Also, these rates may change with every passing year. This model does not take care of these aspects.
  • The growth rate can be higher than the discount rate or the WACC for some time. In such a case, the terminal value calculation will give a negative result and go wrong. Also, a company can show negative free cash flow, and hence, the calculation will again go wrong with the perpetuity growth model.
  • In the case of exit multiples method, the multiples change with time and even between companies. Hence, choosing the correct multiple becomes a challenge and may lead to incorrect results.
Sanjay Bulaki Borad
Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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