Defining Terminal Value
Terminal value (or TV) refers to the value of a project, business or asset beyond its forecasted period when cash flows in the future can be approximated. This value is assigned keeping in mind the assumption that a business will expand at a set growth rate forever following the forecast period. This value is often made up of a large percentage of the overall assessed value.
Exploring the Mechanisms of Terminal Value
As the time frame under consideration increases, so too does the difficulty associated with forecasting. This holds true as far as finances are concerned as well, particularly in terms of approximating what a company’s cash flows will amount to in the future. That said, businesses must be valued. In order to tackle this issue, analysts make use of financial models like the discounted cash flow method. In addition, they keep in mind certain assumptions such that the total value of a project or business can be derived.
Discounted Cash Flow and the Role of Terminal Value
Discounted cash flow sees itself most often used within stock market valuation, corporate acquisitions and for feasible studies. It has been created keeping in mind a theory that postulates that an asset’s value equals all future cash flows that are drawn from it. It is imperative that these cash flows be discounted to the current value. The discount rate in question should be representative of the cost of capital like the interest rate.
Two major aspects of discounted cash flow are forecast period and terminal value. The forecast period ordinarily stays in effect for about five years. Anything that exceeds this time frame results in the accuracy of the projections suffering. It is within this context that calculating terminal value becomes important.
Calculating Terminal Value
Terminal value can be calculated using the following methods.
- Perpetual Growth – Here, businesses are assumed to continue to generate cash flows at a constant rate always. This approach is preferred by academics
- Exit Multiple – The assumption here focuses on a business being sold for a multiple of a given market metric. This approach is preferred by investment professionals.
Understanding the Forms of Terminal Value
1. Perpetuity Method
It is important to make use of discounting since the time value of money creates a gap between the current and future values of a certain amount of money. In the case of business valuation, dividends or free cash flow can be estimated for a certain time frame however the performance of current concerns becomes harder to approximate as the projections apply more deeply into the future. Further, it is hard to determine the exact point in time when a company may stop its operations.
In order to overcome these hurdles, investors are permitted to assume that cash flows will amass at a stable rate forever beginning at some point in time in the future. This is indicative of the terminal value.
The formula for terminal value requires you to divide the last cash flow forecast by the difference that exists between the discount rate and the terminal growth rate. This calculation helps estimate what the value of a company will be following the forecast period.
Terminal Value = [FCF x (1+g)] / (d-g)
Where,
FCF = free cash flow
g = terminal growth rate
d = discount rate
2. Exit Multiple Method
In case investors assume there exist a set number of operations, the perpetuity growth model isn’t needed. Instead, the terminal value must indicate the net realizable value of a company’s assets at that point in time. Most often this means that the equity will be taken over by a bigger firm and the value of acquisitions is frequently formulated with exit multiples.
Exit multiples help approximate a reasonable price by multiplying financial statistics. These include EBITDA, profits or sales by a factor that’s common for firms that are similar and which were recently obtained. The terminal value formula that uses the exit multiple method is the most recent metric that’s multiplied by the multiple that’s been decided upon.
Investment banks tend to favour this approach however some detractors are wary of using intrinsic and relative valuation methods at the same time.
Final Thoughts
A number of companies do not assume that their operations will come to a close after a few years. They anticipate that their businesses will continue for a long time, if not forever. Terminal value helps anticipate what the future valuation of a company will be. This value is then applied to present prices via discounting. Learn more about terminal value on the Angel One website.
