TERMINAL VALUE V. DCF ANALYSIS

 

Terminal Value (TV)

Terminal Value

Terminal value is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Usually, Terminal value assumes a business will grow at a constant growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.

KEY TAKEAWAYS

• Terminal value (TV) determines a company's value into perpetuity beyond a set forecast period—usually five years.
• Analysts use the discounted cash flow model (DCF) to calculate the total value of a business. DCF has two major components—the forecast period and terminal value.
• There are two commonly used methods to calculate terminal value—perpetual growth (Gordon Growth Model) and exit multiple.
• The perpetual growth method assumes that a business will continue to generate cash flows at a constant rate forever, while the exit multiple methods assume that the business will be sold for a multiple of some market metric.

 

Discounted cash flow (DCF) is a popular method used in feasibility studies, corporate acquisitions, and stock market valuation. This method is based on the theory that an asset's value is equal to all future cash flows derived from that asset. These cash flows must be discounted to the present value at a discount rate representing the cost of capital, such as the interest rate.

DCF has two major components: forecast period and terminal value. The forecast period is usually about five years. Anything longer than that and the accuracy of the projections suffer. This is where calculating terminal value becomes important.

Types of Terminal Value

 

Perpetuity Method

Discounting is necessary because the time value of money creates a discrepancy between the current and future values of a given sum of money. In business valuation, free cash flow or dividends can be forecast for a discrete period of time, but the performance of ongoing concerns becomes more challenging to estimate as the projections stretch further into the future. Moreover, it is difficult to determine the precise time when a company may cease operations.

To overcome these limitations, investors can assume that cash flows will grow at a stable rate forever, starting at some point in the future. This represents the terminal value. 

Terminal value is calculated by dividing the last cash flow forecast by the difference between the discount rate and terminal growth rate. The terminal value calculation estimates the value of the company after the forecast period.

The formula to calculate terminal value is:

(FCF * (1 + g)) / (d - g)

Where:

• FCF = Free cash flow for the last forecast period 
• g = Terminal growth rate 
• d = discount rate (which is usually the weighted the average cost of capital)

The terminal growth rate is the constant rate that a company is expected to grow at forever. This growth rate starts at the end of the last forecasted cash flow period in a discounted cash flow model and goes into perpetuity. A terminal growth rate is usually in line with the long-term rate of inflation, but not higher than the historical gross domestic product (GDP) growth rate.

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 methods assume 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.