What is terminal value?
Terminal value (TV) is the value of a business or asset beyond the explicit forecast period, and it’s a critical part of Discounted Cash Flow (DCF) models. This forecast period is usually five to 10 years. In fact, TV usually accounts for about 75% of the total valuation in a DCF model.
Calculating the terminal value helps investors estimate the future value of a business or asset. This calculation is important for forecasting, strategy creation, and investor communication. The accuracy of the calculation for terminal value depends on reasonable assumptions.
There are two main ways to calculate terminal value: the perpetual growth method and the exit multiple method.
Below, we’ll dive into these methods, their uses, and how to estimate TV accurately.
Understanding the Perpetual Growth Method
One common way to calculate terminal value is the perpetual growth method. Let’s break down the principles, formula, and steps involved.
Core Principles of the Perpetual Growth Method
The core assumption of this method is that a company’s cash flow will grow at a constant rate into perpetuity. This works best for mature companies that have stable and predictable growth. The growth rate should be conservative, typically in the range of 2% to 4%.
Key variables include:
- Free Cash Flow (FCF): The cash a company generates after paying for operating expenses and capital expenditures.
- Growth Rate (g): The assumed constant rate at which the company’s free cash flow will grow.
- Weighted Average Cost of Capital (WACC): The minimum rate of return a company needs to earn to satisfy its investors.
Formula and Calculation Steps
The perpetual growth formula is:
Terminal Value = FCF (1 + g) / (WACC – g)
Where:
- FCF = Free cash flow in the final year of the explicit forecast period.
- g = Perpetual growth rate.
- WACC = Weighted average cost of capital.
It’s essential to use the correct formula and to ensure that your units are consistent. For example, if your WACC is 5%, use 0.05 in the formula, not 5. A common mistake is using nominal values instead of real values for both the growth rate and the discount rate.
Example Calculation
Let’s say we have a company with:
- Free cash flow of $400,000
- WACC of 5%
- Estimated terminal growth rate of 3%
Then the terminal value would be:
$400,000 (1 + 0.03) / (0.05 – 0.03) = $20,600,000
The resulting terminal value of $20,600,000 gives us an estimate of the company’s value beyond our explicit forecast period. Keep in mind that terminal values can be positive or negative, depending on the variables you input into the formula.
Exploring the Exit Multiple Method
One of the common ways to calculate terminal value is to use the exit multiple method. Here’s a closer look at how it works.
Underlying Principles
The exit multiple method is a relative valuation method, meaning it relies on the valuations of similar companies to estimate the terminal value of the company you’re analyzing. You find a valuation multiple (like an EBITDA multiple) from those comparable companies and apply it to a financial metric of your company to arrive at the terminal value. This method is most useful when there are publicly traded companies with established valuations that are easy to find.
Picking the right comparable companies is essential to finding an accurate valuation. The companies you compare should be in the same industry, have similar business models, and operate in similar markets. Using an average of several comparable companies can help you avoid outliers that might skew your numbers.
Calculation Process
First, you need to decide what multiple makes the most sense for your industry and the data you have available. Common multiples are EV/EBITDA, EV/Revenue, and Price/Earnings. EV/EBITDA is often preferred because it’s less sensitive to differences in capital structure.
Then, you multiply the multiple by the company’s financial metric in the final year of your forecast period. So, if the company’s Year 5 EBITDA is $60 million and you’ve settled on a multiple of 8x, the terminal value would be $480 million (8 x $60 million).
Considerations and Limitations
Keep in mind that exit multiples are affected by market conditions and can change over time. You’ll want to consider the current market when you’re choosing and applying multiples. Looking at historical averages can help smooth out any short-term ups and downs.
The exit multiple method might not fully capture some company-specific factors that can affect value. Things like competitive advantages, quality of management, and growth prospects should be considered, and you may need to adjust the multiple to reflect these factors.
Key Considerations and Refinements for Terminal Value Calculation
Calculating terminal value isn’t as simple as plugging numbers into a formula. Here are some critical factors to keep in mind and ways to refine your estimations:
Ensuring a Normalized Steady State
Before you cut off the explicit forecast period, make sure the company’s cash flows have matured. A normalized steady state of financial performance is key before you start calculating terminal value. If the company is still growing quickly or undergoing significant changes, hold off on the terminal value calculations.
Also, be sure to normalize the company’s reinvestment needs near the end of the explicit forecast period. That means making sure capital expenditures and working capital investments align with the company’s long-term growth rate. If you don’t normalize reinvestment, your terminal value estimates could be off.
Cross-Checking and Validation
It’s a good idea to cross-check your calculations using both methods to make sure your results are valid. Compare the implied multiples and growth rates from both approaches. If the results are way off, it could mean there’s a problem with your assumptions or calculations.
Also, run a sensitivity analysis to see how different assumptions affect the terminal value. Play around with the growth rate, WACC, and exit multiple to figure out what’s really driving the value. This will give you a range of potential terminal values and help you see how solid your valuation is.
The Role of AI in Refining Estimations
AI can help you refine your terminal value estimations by crunching tons of data and testing different assumptions. AI algorithms can spot patterns and relationships that might be hidden to human analysts, which can make your terminal value calculations more accurate and defensible.
AI can also analyze market data, macroeconomic trends, and company-specific information to give you insights into future growth prospects and valuation multiples. This can give you a more objective and data-driven way to estimate terminal value.
Conclusion
Estimating terminal value is essential in financial modeling, and the perpetual growth and exit multiple methods are the most frequently used. The best approach for your situation will depend on the company you’re evaluating and the data you have available.
The accuracy of your terminal value calculation depends heavily on how reasonable your assumptions are. Take the time to carefully consider the long-term growth rate, WACC, and exit multiple. Validate these assumptions by running a sensitivity analysis and cross-checking your work.
Financial modeling is constantly changing, and new tools and techniques are emerging to help refine terminal value estimations and improve the accuracy of valuations. For example, AI may be helpful in making predictions and identifying patterns. By staying up-to-date on these advancements and incorporating best practices, financial analysts can improve the reliability and usefulness of their terminal value calculations.