Terminal Value​

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 encompasses the value of all future cash flows beyond 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, depending on the type of analysis to be performed.

The exit multiple method assumes that the business is sold for a multiple of a specific 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 because it is based on a mathematical theory.  However, it is challenging to agree on the assumptions that will accurately predict a perpetual growth rate.

Terminal Value: Exit Multiple Method

The terminal value is calculated based on the method (discussed previously) that the analyst will 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)

The 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 accurately predicting a growth rate. 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, which change over time.

Furthermore, long-term growth assumptions and terminal value estimates should reflect structural risks such as customer concentration.

All in all, careful consideration must be given before applying either of the two methods. However, for both methods, using a range of applicable rates and multiples is crucial to obtain an acceptable valuation result.

Additional Resources

Thank you for reading CFI’s guide to Terminal Value. To keep advancing your career, the additional CFI resources below will be useful:

• Pros and Cons of the DCF Model
• Capital Asset Pricing Model
• Valuation Methods
• Financial Modeling Guide
• See all valuation resources