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Terminal Value​

A key component of valuation​

What is Terminal Value?

Terminal Value (TV) is the estimated present value of a business beyond the explicit forecast period. TV is used in various financial tools such as the Gordon Growth Model, the discounted cash flow, and residual earnings computation. However, it is mostly used in discounted cash flow analyses.

 

What is the Importance of the Terminal Value?

In financial analysis, the terminal value includes the value of all future cash flows outside of a particular projection period. It captures values that are otherwise difficult to predict using the regular financial model forecast period. There are two methods used to calculate the terminal value, which depends on the type of analysis to be done.

The exit multiple method 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 perpetuity growth model assumes that cash flow values grow at a constant rate ad infinitum. Because of this assumption, the formula for perpetuity with growth can be used. The perpetuity growth model is preferred among academics as there is a mathematical theory behind it.  However, it is difficult to agree on the assumptions that will predict an accurate perpetual growth rate.

 

terminal value

 

Terminal Value: Exit Multiple Method

Terminal value is calculated based on what method (discussed previously) the analyst is going to use. Under the exit multiple method, TV is calculated as follows:

TV = Last Twelve Months Exit Multiple x Projected Statistic

The exit multiple can be the enterprise value/EBITDA or enterprise value/EBIT, which are the usual multiples used in financial valuation. The projected statistic, on the other hand, is the relevant statistic projected in the previous year.

 

Terminal Value: Perpetuity Growth Model

Meanwhile, under the perpetuity growth model, the terminal value is calculated as follows:

TV = (Free Cash Flow x (1 + g)) / (WACC – g)

Where:

  • Free Cash Flow = FCF for the last twelve months
  • WACC = Weighted Average Cost of Capital
  • G = Perpetual growth rate (or sustainable growth rate)

Perpetuity growth rate is usually equivalent to the inflation rate and almost always less than the economy’s growth rate. If the growth rate changes, a multiple-stage terminal value can then be determined instead.

 

What are the Limitations of Using the Terminal Value?

As mentioned previously, the perpetuity growth model is limited by the difficulty of predicting an accurate growth rate. Furthermore, any assumed value in the equation can lead to inaccuracies in the calculated terminal value. On the other hand, the exit multiple method is limited by the dynamic nature of multiples – they change as time passes.

All in all, careful considerations must be in place before applying any of the two methods. But for both methods, using a range of applicable rates and multiples is important in order to get an acceptable valuation result.

 

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to help anyone become a world-class financial analyst.

Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Pros and Cons of DCF Model
  • Capital Asset Pricing Model
  • Valuation Methods
  • Financial Modeling Guide

Valuation Techniques

Learn the most important valuation techniques in CFI’s Business Valuation course!

Step by step instruction on how the professionals on Wall Street value a company.

 

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