How to Calculate the Present Value of Terminal Value

Terminal value is a fundamental concept in financial valuation, especially within discounted cash flow (DCF) analysis. It represents the estimated value of a company’s operations beyond a typical explicit forecast period, which commonly spans five to ten years. This component is significant because it captures the long-term value a business is expected to generate indefinitely into the future. Essentially, terminal value accounts for the cash flows a company will produce once it reaches a stable growth phase.

Understanding Terminal Value in Valuation

Terminal value represents a company’s estimated worth beyond the initial explicit forecast period in a discounted cash flow model. While DCF models project free cash flows for a limited number of years, typically three to ten, it is impractical to forecast indefinitely. Terminal value encapsulates the business’s value in perpetuity after this initial period.

This value often constitutes a substantial portion of a company’s total estimated valuation, frequently ranging from 50% to 80% or higher. Businesses are generally assumed to operate as going concerns, generating cash flows beyond any foreseeable forecast horizon. After the explicit forecast period, a company is presumed to reach a stable state of growth and profitability, which the terminal value reflects.

Methods for Calculating Terminal Value

Calculating terminal value involves two primary methodologies: the Perpetual Growth Model, also known as the Gordon Growth Model, and the Exit Multiple Method. Each approach offers a distinct perspective on how to estimate a company’s long-term worth. Analysts often employ both methods to cross-check assumptions and enhance the reliability of their valuation.

Perpetual Growth Model (Gordon Growth Model)

The Perpetual Growth Model assumes a company’s free cash flows will grow at a constant rate indefinitely after the explicit forecast period. The formula is: Terminal Value = [FCFn × (1 + g)] / (WACC – g), where FCFn is the free cash flow in the last year of the explicit forecast period, ‘g’ is the perpetual growth rate, and WACC is the weighted average cost of capital. This method applies when a company is expected to maintain steady operations and growth.

FCFn, the free cash flow in the final year of the explicit forecast, should represent a normalized, stable cash flow. The perpetual growth rate (‘g’) should reflect a realistic and sustainable long-term growth rate. This rate should not exceed the long-term inflation rate or the overall economic growth rate, as a company cannot grow faster than the economy indefinitely.

The Weighted Average Cost of Capital (WACC) serves as the discount rate and represents the overall cost of capital for the business, reflecting the blended cost of its debt and equity. WACC calculation considers the market value of equity and debt, their respective costs, and the corporate tax rate. The cost of equity can be estimated using models like the Capital Asset Pricing Model (CAPM). The cost of debt is typically the yield to maturity on the company’s debt, adjusted for tax deductibility.

Exit Multiple Method

The Exit Multiple Method estimates terminal value by applying a market multiple to a relevant financial metric in the last year of the explicit forecast period. The formula is: Terminal Value = Financial Metricn × Exit Multiple. This approach assumes that the business will be sold or valued based on how comparable companies are trading in the market at the end of the forecast period.

Common financial metrics used for this method include Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), Earnings Before Interest and Taxes (EBIT), or Revenue. The choice of metric often depends on industry standards and the specific characteristics of the company being valued. For instance, EBITDA multiples are frequently used for mature businesses with stable profit margins.

Selecting an appropriate exit multiple involves analyzing comparable public companies or recent acquisition transactions within the same industry. This multiple should reflect the company’s expected state at the end of the forecast period, considering its growth potential, market position, and financial performance.

Discounting Terminal Value to Present

After calculating terminal value using either the Perpetual Growth Model or the Exit Multiple Method, the next step is to discount this future value back to the present day. This process aligns the terminal value with the present value of explicit forecast period cash flows, allowing for a comprehensive company valuation. Discounting accounts for the time value of money, recognizing that a dollar today is worth more than a dollar in the future.

The formula to discount the terminal value to the present is: Present Value of Terminal Value = Terminal Value / (1 + WACC)^n. In this formula, “TV” represents the terminal value calculated at the end of the explicit forecast period. “WACC” is the weighted average cost of capital, which serves as the appropriate discount rate for the company’s unlevered free cash flows.

The variable ‘n’ represents the number of years from the valuation date to the point the terminal value is calculated. This ‘n’ is the length of the explicit forecast period. For example, if the explicit forecast period is five years, the terminal value calculated at the end of year five would be discounted back five years to the present day.

After discounting the terminal value, this present value of the terminal value is then added to the present value of the free cash flows projected during the explicit forecast period. This sum provides the total enterprise value of the company, which represents the value of its operating assets.

Key Considerations in Terminal Value Analysis

Terminal value calculations are sensitive to underlying assumptions, requiring careful consideration of inputs for reliable valuations. Small adjustments to key variables can lead to variations in the final terminal value and overall company valuation. This sensitivity is particularly pronounced for the perpetual growth rate and the weighted average cost of capital in the Gordon Growth Model, and the chosen exit multiple in the Exit Multiple Method.

The choice between the Perpetual Growth Model and the Exit Multiple Method depends on factors like company maturity, industry stability, and comparable market data availability. The Exit Multiple Method is often favored for its market-driven perspective, especially when reliable comparable company data is available. Conversely, the Perpetual Growth Model is more appropriate for mature companies expected to maintain a stable, long-term growth trajectory. It is common practice to calculate terminal value using both methods and compare the results.

Assumptions must be realistic. The perpetual growth rate should be sustainable, not exceeding the long-term growth rate of the broader economy or expected inflation. An excessively high growth rate implies a company will outgrow the entire economy, which is unrealistic. Consistency between assumptions used in the explicit forecast period and for the terminal value is important for a coherent valuation model.

Performing sanity checks on the calculated terminal value helps validate the valuation. This can involve comparing the implied growth rate from the Exit Multiple Method to economic growth rates or analyzing the implied multiple from the Gordon Growth Model against market comparables. Analysts also assess the proportion of the total enterprise value that the present value of terminal value represents. If the terminal value accounts for a high percentage, it may indicate overly aggressive assumptions.