TERMINAL VALUE

Terminal Value (TV) is the value of an asset, business or project beyond the forecasted period when future cash flows can be estimated

Terminal value assumes a business will grow at a set growth rate forever after the forecast period

Terminal value often comprises a large percentage of the total assessed value

Terminal value as per Finance

In finance, the terminal value of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever

Terminal value calculation

TV = (FCFn X (1+g))/ (WACC – g)

TV = terminal value

FCF = free cash flow

n = year 1 of terminal period or final year

g = perpetual growth rate of FCF

WACC = weighted average cost of capital

The terminal value of a project

Terminal value is the value of a project’s expected cash flow beyond the explicit forecast horizon

An estimate of the terminal value is critical in financial modeling as it accounts for a large percentage of the project value in a discounted Cash flow valuation

Terminal value discounting

Typically, an assets terminal value is added to future cash flow projections and discounted to the present day

Discounting is performed because the terminal value is used to link the money value between two different points in time

Terminal cash flow

Terminal cash flows are cash flows at the end of the project after all taxes are deducted

Ways of estimating Terminal Value

1) Liquidation value

Most useful when assets are separable and marketable

2) Multiple Approach

Easiest approach but makes the valuation a relative valuation

3) Stable Growth Model

Technically soundest, but requires that you make judgments about when the firm will grow at a stable rate that can sustain forever, and the excess returns (if any) that it will earn during the period

Terminal year

Terminal year refers to the year in which an individual dies, in the context of estate planning and taxation

Special tax rules and handling of income and assets may apply during the taxpayer’s final year

Terminal multiple

Terminal multiple method assumes that the enterprise value of the business can be calculated at the end of the projected period by using existing multiples on comparable companies

Key takeaways of terminal value

1) Terminal value (TV) determines a company’s value into perpetuity beyond a set forecast period – usually five years

2) analysts use discounted Cash flow model (DCF) to calculate the total value of a business

The forecast period and terminal value are both integral components of DCF

3) the two most common methods for calculating terminal value are perpetual growth (Gordon Growth Model) and exit multiple

4) the perpetual growth method assumes that a business will generate cash flows at a constant rate forever, while the exit multiple method assumes that a business will be sold

Meaning of Negative Terminal Value

A negative terminal value would be estimated if the cost of future capital exceeded the assumed growth rate

Negative terminal valuations cannot exist for very long

A company’s equity value can only realistically fall to zero at a minimum, and any remaining liabilities would be stored out in a bankruptcy proceeding

Limitations of Terminal Value

1) the growth rate and the discount rate are assumptions in the perpetuity growth model

2) the growth rate can be higher than the discount rate or the WACC for some time

3) in the case of the exit multiples method, the multiples change with time and even between companies

The reasonable growth rate for a terminal value

The terminal growth rates typically range between the historical inflation rate (2% – 3%) and the average GDP growth rate (3% – 4%) at this stage

A terminal growth rate higher than the average GDP growth indicates that the company expects it’s growth to outperform that the economy forever

Compiled by

Avinash Kulkarni

Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer