HOW TO CALCULATE TERMINAL VALUE IN A DCF ANALYSIS
Terminal value is the estimated value of a business beyond the explicit forecast period in a discounted cash flow (DCF) analysis. It represents the expected value of all future cash flows that a company is expected to generate beyond the forecast period, discounted to their present value.
There are two main approaches to calculating terminal value in a DCF analysis: the perpetual growth method and the exit multiple method.
- Perpetual Growth Method: This approach assumes that the company will continue to grow its cash flows indefinitely at a constant growth rate beyond the forecast period. The formula for calculating terminal value using the perpetual growth method is:
Terminal Value = Final year’s Free Cash Flow * (1 + Long-term Growth Rate) / (Discount Rate – Long-term Growth Rate)
Where, Free Cash Flow = Cash flow generated by the company in the final year of the explicit forecast period Long-term Growth Rate = Expected rate of growth in perpetuity beyond the explicit forecast period Discount Rate = The required rate of return on investment
For example, suppose a company generates a free cash flow of $100 million in the final year of a 5-year forecast period, and we assume a long-term growth rate of 3% and a discount rate of 10%. The terminal value can be calculated as:
Terminal Value = $100 million * (1 + 3%) / (10% – 3%) = $1,391 million
- Exit Multiple Method: This approach estimates the terminal value based on a multiple of a key financial metric such as EBITDA, revenue or net income. The formula for calculating terminal value using the exit multiple method is:
Terminal Value = Final year’s EBITDA * Exit Multiple
Where, EBITDA = Earnings before interest, taxes, depreciation, and amortization generated by the company in the final year of the explicit forecast period Exit Multiple = Expected market multiple at the end of the explicit forecast period
For example, suppose a company generates an EBITDA of $200 million in the final year of a 5-year forecast period, and we assume an exit multiple of 12x. The terminal value can be calculated as:
Terminal Value = $200 million * 12 = $2,400 million
After calculating the terminal value, it is discounted back to its present value using the discount rate to arrive at the total enterprise value of the company. This enterprise value is then compared to the current market value of the company to determine whether the stock is undervalued or overvalued.
