How to Calculate the Present Value of Terminal Value

Financial valuation often requires estimating a company’s worth or a project’s potential beyond immediate financial projections. Terminal value represents the value generated by a business or asset beyond a defined explicit forecast period, capturing its ongoing contributions. Understanding how to determine and discount this future value to the present day is essential for comprehensive valuation. This article will guide the reader through understanding terminal value components and methods for calculating its present-day equivalent.

What is Terminal Value

Terminal value represents the estimated value of a company or project at the end of a specific forecast period, typically five to ten years. It captures the value of all cash flows that are expected to occur after this explicit forecast period, assuming the business continues to operate indefinitely. This concept is fundamental in various valuation methodologies, particularly in discounted cash flow (DCF) analysis, where it often accounts for a significant portion of the total valuation. Without terminal value, a DCF model would only account for cash flows within the explicit forecast period, understating the true worth of an ongoing enterprise.

The explicit forecast period is a duration for which detailed financial projections, such as revenue, expenses, and capital expenditures, are made. Beyond this period, forecasting individual line items with accuracy becomes difficult, necessitating a simplified approach to capture long-term value. Terminal value bridges this gap, providing a single figure that encapsulates the long-term, stable growth phase of a business. It assumes that, after the explicit forecast period, the business will either grow at a constant, sustainable rate into perpetuity or be sold based on a market multiple.

Two primary approaches estimate terminal value: the Gordon Growth Model and the Exit Multiple Method. The Gordon Growth Model, also known as the Perpetuity Growth Model, assumes a company’s free cash flows will grow at a constant rate indefinitely after the explicit forecast period. This method suits mature companies with stable, predictable cash flows. The Exit Multiple Method estimates terminal value by applying a market multiple, such as an enterprise value to EBITDA ratio, to a relevant financial metric of the company in the terminal year. This approach is favored when comparable transactions or publicly traded companies are available to derive appropriate multiples.

Methods for Calculating Terminal Value

Calculating terminal value requires considering a company’s long-term prospects and market conditions, typically employing either the Gordon Growth Model or the Exit Multiple Method.

Gordon Growth Model

The Gordon Growth Model is particularly useful when a business is expected to achieve a stable, perpetual growth rate in its cash flows. The formula for the Gordon Growth Model is: Terminal Value = FCF (1 + g) / (WACC – g). “FCF” represents the free cash flow in the last year of the explicit forecast period, projected to grow at a constant rate.

The “g” denotes the perpetual growth rate of the company’s free cash flows, reflecting a sustainable long-term growth trajectory. This growth rate is typically lower than historical or near-term projected rates and often set below the expected long-term nominal gross domestic product (GDP) growth rate to ensure a realistic estimate. The “WACC” represents the Weighted Average Cost of Capital, the average rate of return a company expects to pay to its investors, considering both debt and equity. For instance, if a company’s free cash flow in the terminal year is $100 million, the perpetual growth rate is 2%, and the WACC is 8%, the terminal value would be $100 million (1 + 0.02) / (0.08 – 0.02), resulting in approximately $1.7 billion.

Exit Multiple Method

Alternatively, the Exit Multiple Method determines terminal value by applying a multiple derived from comparable market transactions or publicly traded companies. The formula for this method is: Terminal Value = Terminal Year Metric Exit Multiple. Common financial metrics include Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), Earnings Before Interest and Taxes (EBIT), or revenue. For example, if the chosen metric is EBITDA, the terminal value would be calculated by multiplying the projected EBITDA in the terminal year by an appropriate enterprise value to EBITDA multiple.

Selecting an appropriate exit multiple involves analyzing recent acquisition multiples for similar companies or current trading multiples of publicly traded peers. This requires careful judgment, considering factors such as industry trends, company size, and growth prospects relative to the comparable set. For instance, if a company’s projected EBITDA in the terminal year is $150 million and the average enterprise value to EBITDA multiple for comparable companies is 7x, the terminal value would be $150 million 7, equaling $1.05 billion. Both methods provide an estimate of the future value of the business, which then needs to be discounted back to the present.

Determining the Present Value of Terminal Value

Once the terminal value has been calculated using either the Gordon Growth Model or the Exit Multiple Method, the next essential step is to discount this future value back to the present day. This discounting process is necessary due to the time value of money, which posits that a dollar today is worth more than a dollar received in the future because of its potential earning capacity. The present value calculation converts the future terminal value into an equivalent value in today’s dollars, allowing it to be aggregated with the present value of the explicit forecast period’s cash flows.

The present value formula for a single future sum is applied to achieve this: PV = FV / (1 + r)^n. In this context, “PV” represents the present value of the terminal value, which is the figure we aim to calculate. The “FV” component is the terminal value itself, which was derived from the calculations in the previous section. This “FV” is the large lump sum estimated to be received at the end of the explicit forecast period.

The “r” in the formula signifies the discount rate, which is typically the Weighted Average Cost of Capital (WACC) for a company valuation. WACC reflects the overall cost of capital for the business and is used to discount all future cash flows, including the terminal value, back to the present. The “n” represents the number of years from the valuation date to the point in time when the terminal value is realized, which is the end of the explicit forecast period. This “n” aligns with the last year of the detailed financial projections.

To illustrate, if the calculated terminal value (FV) is $1.5 billion, the WACC (r) is 9%, and the explicit forecast period (n) is 10 years, the present value of the terminal value would be $1.5 billion / (1 + 0.09)^10. This calculation would yield approximately $633 million as the present value contribution of the terminal value to the overall valuation. This step ensures that the terminal value is correctly incorporated into a current valuation.

Key Variables Affecting Terminal Value and its Present Value

The estimation of terminal value and its subsequent present value is highly sensitive to changes in its underlying inputs, making careful consideration of these variables important. In the Gordon Growth Model, the perpetual growth rate (“g”) is a particularly influential variable. Even small adjustments to this growth rate can lead to significant differences in the calculated terminal value. A higher assumed growth rate implies a larger stream of future cash flows extending indefinitely, thereby increasing the terminal value and its present value.

The Weighted Average Cost of Capital (WACC) also plays a dual role in affecting both the calculation of terminal value (in the Gordon Growth Model) and the discounting process for both methods. In the Gordon Growth Model, WACC is in the denominator, meaning a higher WACC reduces the terminal value directly. Furthermore, when discounting the terminal value back to the present, a higher WACC (the “r” in the present value formula) results in a lower present value. This occurs because a higher discount rate implies a greater opportunity cost of capital, making future cash flows less valuable in today’s terms.

For the Exit Multiple Method, the chosen multiple significantly drives the resulting terminal value. The multiple is typically derived from market data, and its selection requires professional judgment. An increase in the multiple, perhaps due to improved market sentiment or better comparable transactions, will directly lead to a higher terminal value. Conversely, a decrease in the multiple will reduce the terminal value.

Given the substantial portion of total valuation that terminal value often represents, the accuracy and justification of these input variables are important. Small errors or biases in estimating the perpetual growth rate, WACC, or the exit multiple can materially impact the overall valuation conclusion. Financial analysts dedicate considerable effort to rigorously analyze and support the assumptions underpinning these variables.