How to Calculate Horizon Value With Two Key Methods
Calculate horizon value for accurate financial valuations. Discover practical methods to estimate long-term business worth.
Calculate horizon value for accurate financial valuations. Discover practical methods to estimate long-term business worth.
Horizon value, also known as terminal value, represents the estimated worth of a business or asset beyond its explicit forecast period in a financial model. This value captures the long-term cash flow generation capacity once its growth is expected to stabilize. It is a significant element within discounted cash flow (DCF) analysis. Horizon value often accounts for over 50% of a company’s total estimated value, making its calculation fundamental for accurate business valuation.
Calculating horizon value relies on several financial inputs that quantify future expectations and risk. A discount rate serves to convert future cash flows into their present-day equivalent, reflecting the time value of money and the inherent risks associated with an investment. This rate is typically the Weighted Average Cost of Capital (WACC), blending the costs of debt and equity financing. The cost of equity might be derived using models like the Capital Asset Pricing Model (CAPM).
The stable growth rate, often denoted as ‘g’, is another input. This rate represents the perpetual growth of cash flows after the explicit forecast period. It is generally a conservative rate an economy can sustain indefinitely, typically not exceeding long-term nominal GDP growth. An appropriate stable growth rate ensures realistic and achievable perpetual growth.
The terminal period cash flow or metric provides the starting point for the horizon value calculation. This refers to the last projected cash flow (e.g., Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE)) from the explicit forecast period. For multiples, it could be a financial metric like EBITDA or net income. This final cash flow or metric must be normalized to reflect sustainable operations, free from unusual or non-recurring events.
The Gordon Growth Model (GGM) is a common method for determining horizon value, assuming cash flows grow at a constant rate indefinitely. The formula for the GGM is expressed as: HV = [Cash Flow at (T+1)] / (Discount Rate – Stable Growth Rate). This model is particularly sensitive to its inputs, necessitating careful consideration of each variable.
The initial step involves projecting the cash flow for year (T+1), the first year beyond the explicit forecast period. This is typically achieved by growing the final normalized cash flow from the explicit forecast period (year T) by the chosen stable growth rate. For example, if the normalized cash flow in year T is $100 million and the stable growth rate is 2%, the cash flow for year (T+1) would be $102 million.
Identifying the appropriate discount rate, which reflects the cost of capital, is the next step. This rate accounts for the investment’s risk and opportunity cost. Simultaneously, the stable growth rate must be determined. This rate should align with long-term economic averages and be lower than the discount rate to ensure a mathematically sound and finite horizon value.
Once these components are established, they are directly applied to the GGM formula. If the cash flow for year (T+1) is $102 million, the discount rate is 8%, and the stable growth rate is 2%, the horizon value would be calculated as $102 million / (0.08 – 0.02), resulting in $1,700 million. This calculated horizon value represents the business’s worth at the end of the explicit forecast period. For a full DCF analysis, it must be discounted back to the present day using the same discount rate to determine its present value contribution.
The multiples approach provides an alternative method for estimating horizon value by applying a market-derived multiple to a relevant financial metric in the terminal year. This method assumes that the company will be valued similarly to comparable public companies or recent transactions at the end of the forecast period. Common multiples employed include Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), Price-to-Earnings (P/E), or EV to Sales.
The first step involves identifying the relevant financial metric for the terminal period, which is typically the last year of the explicit forecast. This metric could be EBITDA or net income, depending on the chosen multiple, and should be normalized to reflect sustainable operations. For instance, if using an EV/EBITDA multiple, the normalized EBITDA from year T would be the basis for the calculation.
Selecting an appropriate market multiple is the next step. This often involves analyzing comparable publicly traded companies within the same industry or recent acquisition transactions. Analysts typically consider factors such as business model, growth prospects, profitability, and risk profile when identifying suitable comparables. The chosen multiple should represent a reasonable market valuation for a mature, stable business.
Applying the selected multiple to the terminal period financial metric yields the horizon value. For example, if the normalized EBITDA in year T is $150 million and the chosen EV/EBITDA multiple is 7.0x, the horizon value would be $150 million multiplied by 7.0, resulting in $1,050 million. This value represents the business’s estimated worth at the end of the explicit forecast period. Similar to the Gordon Growth Model, it must be discounted back to the present value for a comprehensive DCF analysis.