Terminal value is a concept used often in financial modeling. It represents the value of an asset or a business projected beyond the forecasted period when future cash flows can be estimated. Forecasting gets murkier the longer the time horizons, so in order to get a more accurate terminal value, analysts often rely on some key assumptions. Let’s find out what terminal value is and what assumptions are needed to calculate the terminal value.
1. What is Terminal Value?
Terminal value (TV) is the present value of a business estimated beyond the explicit forecast period, which is often between 1 to 5 years. In other words, it captures the value of all future cash flows outside of the projection period assuming that the business will continue to be operational until then. Terminal value is often used in financial models such as the Gordon Growth Model or the discounted cash flow.
2. How does Terminal Value work?
There are two ways of arriving at the terminal value and each works a different way.
The first method is the perpetuity approach. Under this approach, we assume that the free cash flow of the last projected year will be stable, so it is discounted at a WACC rate to find the present value of the expected future cash flow. The perpetuity approach is often more favored by academics because there is a mathematical theory underlying the model. However, forecasting a company’s value to perpetuity tends to be less accurate as the assumptions that help predict the terminal value are hard to be agreed on.
The second method is the exit multiple method. This approach assumes that the business has a finite operation time and at the end of the time, the business will be acquired or sold. The exit multiple method accounts for the realizable value of the company at the end of the projected period of operations using financial multiples derived from the comparison with other comparable companies or transactions. This value is then discounted to the present value to arrive at the present value of the enterprise or equity.
3. Terminal Value Formula
LTM FCF: Last 12 months free cash flow
G: Perpetual growth rate (or sustainable growth rate). The perpetual growth rate should be below the long-term GDP growth rate of the country (because the company cannot outgrow the entire economy) and often be above the long-term inflation rate. That said, it is often between 1% to 3% for US companies and can be up to 5 or 6% for emerging markets.
Exit Multiple Method
There are several options for the exit multiple. The exit multiple can be EV/EBITDA for most of the company. There are also some specific exit multiples for some particular industries like natural resources or financial institutions. The projected metrics are the relevant metric under the multiple of your choice projected in the previous year.
4. Limitations of Terminal Value Formula
Calculating the terminal value of a business is extremely hard. It is therefore not surprising that these formulas can have some severe limitations.
As said earlier, the perpetuity approach is more favored by academics because there is a mathematical theory behind it. While the calculation is theoretically sound, the input of it can be murky sometimes. It is virtually impossible to predict an accurate perpetual growth rate of a business since there are just too many assumptions about the future. The WACC calculation itself, in addition, can be distorted by external assumptions like tax rates or beta.
The exit multiple approach likewise is constrained in its robustness by the dynamic nature of multiples. Multiple changes as time passes and can be inconsistent depending on accounting practices by each company. In addition, constructing a list of comparable companies to estimate the multiple is not 100% perfect given the fact that it is really hard to find truly comparable companies or transactions.
There are, however, several ways to make the output more robust, both of which are really helpful in financial modeling. One way for you to make your output more robust is to follow both approaches then take the weighted average of the two. Depending on which method you believe is more accurate, you will give more weight to it. The second option is sensitivity analysis. Sensitivity (or What-if) analysis in Excel helps us to deal with the uncertainty coming from having to predict, project, and assume different input variables. It allows users to observe different output possibilities given 1 to 2 variables or assumptions.
Conclusion: Terminal value is an important concept that you should know before any entry-level investment banking jobs. We hope that you are able to understand terminal value and how to calculate it after reading the article.