When valuing a company, investors often look to the future to determine its potential value. However, predicting future cash flows can be challenging. One method that investors use to estimate a company’s value is by calculating the terminal value, or the value of a company’s future cash flows beyond a certain period. In this article, we’ll explore the definition of terminal value, how to calculate it, and its importance in valuation.
What is Terminal Value?
Terminal value, also known as continuing value, is the estimated value of a company’s future cash flows beyond a certain period, typically five to ten years. It represents the present value of all cash flows that will occur beyond the forecast period.
The reason terminal value is important is that it allows investors to consider a company’s future cash flows beyond the forecast period, which can be difficult to predict with accuracy. By estimating the terminal value, investors can get a better understanding of the overall value of the company.
How to Calculate Terminal Value
There are several methods to calculate terminal value, but two of the most commonly used methods are the perpetuity growth method and the exit multiple method.
Perpetuity Growth Method
The perpetuity growth method assumes that a company will continue to grow its cash flows at a constant rate forever. To calculate the terminal value using this method, you’ll need to know the company’s free cash flow, discount rate, and expected growth rate.
The formula for calculating terminal value using the perpetuity growth method is:
Terminal Value = (FCFn × (1 + g)) / (r – g)
Where: FCFn = Free cash flow in the final year of the forecast period g = Expected growth rate of free cash flow r = Discount rate
For example, let’s assume that a company has a free cash flow of $100 million in the final year of the forecast period, a discount rate of 10%, and an expected growth rate of 2%. Using the formula above, the terminal value would be:
Terminal Value = (100 × (1 + 0.02)) / (0.10 – 0.02) = $1,266.67 million
Exit Multiple Method
The exit multiple method assumes that a company’s future cash flows will be a multiple of a certain metric, such as earnings or EBITDA. To calculate the terminal value using this method, you’ll need to know the company’s earnings or EBITDA for the final year of the forecast period and the industry average multiple for that metric.
The formula for calculating terminal value using the exit multiple method is:
Terminal Value = Earnings or EBITDA in the final year of the forecast period x Industry average multiple for that metric
For example, let’s assume that a company has earnings of $50 million in the final year of the forecast period and the industry average multiple for earnings is 15x. Using the formula above, the terminal value would be:
Terminal Value = $50 million x 15 = $750 million
Importance of Terminal Value in Valuation
Calculating the terminal value is an important step in determining the overall value of a company. It allows investors to consider a company’s future cash flows beyond the forecast period, which can be difficult to predict with accuracy.
The terminal value also helps investors to assess the sustainability of a company’s cash flows. If the terminal value is significantly higher than the company’s current value, it suggests that the company has sustainable cash flows beyond the forecast period, which could make it a more attractive investment.
However, it’s important to note that the accuracy of the terminal value depends on the accuracy of the assumptions used to calculate it. If the growth rate or multiple used in the calculation is too high or too low, it can significantly impact the estimated terminal value and overall valuation of the company. As such, it’s essential to carefully consider the assumptions used in the calculation and to incorporate a range of scenarios to account for uncertainty.
In addition to being used in valuation, terminal value is also important in financial modeling. Financial models often require assumptions about a company’s future cash flows, and the terminal value provides a way to extend these assumptions beyond the forecast period.
Conclusion
In summary, terminal value is the estimated value of a company’s future cash flows beyond a certain period. There are several methods to calculate terminal value, including the perpetuity growth method and the exit multiple method. Calculating the terminal value is an important step in determining the overall value of a company, as it allows investors to consider a company’s future cash flows beyond the forecast period. However, it’s important to carefully consider the assumptions used in the calculation and to incorporate a range of scenarios to account for uncertainty.
