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Terminal value (TV) is a financial concept that estimates the present value of a business or an asset beyond a specific forecast period. It frequently forms a significant component of the total value of a corporation and is employed in valuation techniques like discounted cash flow (DCF) analysis.
For a company or an asset, predicting future cash flows can be difficult, especially as the time horizon gets longer. When estimating sales, expenses, growth rates, and other factors that affect cash flows, there are a lot of unknowns and assumptions involved. In order to produce more accurate projections based on past data and industry trends, analysts typically confine their forecasts to a suitable time frame, such as three to five years.
Although this does not necessarily imply that the company or the asset will stop producing cash flows after the anticipated period, it does imply that it might. As a matter of fact, the majority of companies and assets have limitless lifetimes and will always be profitable for their owners or investors. Analysts estimate the present value of all future cash flows that will occur beyond the forecast period using terminal value to capture this value.
There are two common methods to calculate terminal value: the perpetual growth method and the exit multiple method.
Perpetual Growth Method
The perpetual growth method makes the assumption that the asset or business will continue to expand at a steady rate even after the forecast period has passed. Typically, this rate is lower or equal to the long-term economic growth rate or inflation rate. The formula for terminal value using this method is:TV = FCF * (1 + g) / (r - g)
Where:
TV = Terminal Value
FCF = Free Cash Flow in the last year of forecast
g = Perpetual Growth Rate
r = Discount Rate
The discount rate is usually calculated using the weighted average cost of capital (WACC), which reflects the required return on equity and debt financing for the business or asset.
Exit Multiple Method
The exit multiple technique makes the assumption that the company or asset will be sold for more than some financial statistic, such as earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue, at the conclusion of the projection period. This multiple is derived from comparable sales or market multiples seen for related companies or assets. The formula for terminal value using this method is:TV = E * M
Where:
TV = Terminal Value
E = EBITDA or Revenue in last year of forecast
M = Exit Multiple
Which Method Should We Use?
There are benefits and drawbacks to both approaches. The perpetual growth method is theoretically more sound, but it is based on growth rate projections that might not be practical or in line with market expectations. The exit multiple method is more practical, but it is also more subject to market conditions and the availability of comparable deals.The choice of method depends on several factors, such as:
- The type and traits of the asset or business
- The quantity and caliber of data and information available.
- The objective and setting for valuation
- User and stakeholder preferences and expectations
