What terminal value is, how to calculate it, and how it's used in a DCF analysis
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Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the financial model, as it typically makes up a large percentage of the total value of a business. There are two approaches to the DCF terminal value formula: (1) perpetual growth, and (2) exit multiple.
When building a Discounted Cash Flow / DCF model, there are two major components: (1) the forecast period and (2) the terminal value.
The forecast period is typically 3-5 years for a normal business (but can be much longer in some types of businesses, such as oil and gas or mining) because this is a reasonable amount of time to make detailed assumptions. Anything beyond that becomes a real guessing game, which is where the terminal value comes in.
What is the Perpetual Growth DCF Terminal Value Formula?
The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has a mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity).
The formula for calculating the perpetual growth terminal value is:
What is the Exit Multiple DCF Terminal Value Formula?
The exit multiple approach assumes the business is sold for a multiple of some metric (e.g., EBITDA) based on currently observed comparable trading multiples for similar businesses.
The formula for calculating the exit multiple terminal value is:
TV = Financial Metric (e.g., EBITDA) x Trading Multiple (e.g., 10x)
Which Terminal Value Method is More Common?
The exit multiple approach is more common among industry professionals, as they prefer to compare the value of a business to something they can observe in the market. You will hear more talk about the perpetual growth model among academics since it has more theory behind it. Some industry practitioners will take a hybrid approach and use an average of both.
Example from a Financial Model
Below is an example of a DCF Model with a terminal value formula that uses the Exit Multiple approach. The model assumes an 8.0x EV/EBITDA sale of the business that closes on 12/31/2022.
As you will notice, the terminal value represents a very large proportion of the total Free Cash Flow to the Firm (FCFF). In fact, it represents approximately three times as much cash flow as the forecast period. For this reason, DCF models are very sensitive to assumptions that are made about terminal value.
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