Terminal Value – Definition and Calculation

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What is Terminal Value?

Terminal value or horizon value is an important metric for forecasting future cash flow. Generally, the terminal value represents the present value of a future cash flow taking the growth as a common rate of perpetuity.

There are many uses of terminal value but the most prominent use of terminal value is found in calculating the discounted cash flow (DCF). So, the terminal value is of vital importance for anyone who needs to do a DCF calculation.

Significance of Terminal Value

As is obvious, calculating a future value of anything with 100% accuracy is a challenging task. This is more applicable to something as highly volatile as cash flow. However, businesses and assets must be valued as correctly as possible in all types of business. That is why, financial models like DCF are useful, as they are used to calculate the total value of a business or project.

Terminal value is one of the two components of DCF and hence terminal value must be of utmost importance to business owners and investors. Terminal value’s importance is also because forecasting the future cash flow is vital for all businesses and projects.

Estimating the Terminal Value of a Business

There are primarily two methods of calculating the terminal value of a business.

Perpetual Growth DCF formula for Calculating the Terminal Value

The perpetual growth model is the preferred method for calculating terminal because it has a mathematical base at its core. This model assumes that the business will generate free cash flow at a constant rate forever like perpetuity.

The formula is,

$$\mathrm{Terminal\:Value= \frac{FCF_{n}\times \left ( 1\: +\: g \right )}{WACC - g} }$$

Where −

  • TV = terminal value

  • FCF = Free cash flow

  • n = Year 1 of terminal period or final year

  • g = Perpetual growth rate of FCF

  • WACC = Weighted average cost of capital

Exit Multiple DCF Formulae

This model assumes the business is sold for a multiple of some metric (e.g., EBITDA) based on currently observed comparable trading multiples for businesses that are similar.

The formula for calculating the exit multiple terminal values is −

𝐓𝐕 = 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐌𝐞𝐭𝐫𝐢𝐜 (𝐞. 𝐠. , 𝐄𝐁𝐈𝐓𝐃𝐀) × 𝐓𝐫𝐚𝐝𝐢𝐧𝐠 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞 (𝐞. 𝐠. , 𝟏𝟎𝐱)

Importance of Terminal Value

As is obvious, a terminal value is an indispensable tool for businesses to calculate the future value or cash flow of a business or a project.

  • It is imperative that forecasting any future operation or occurrence is tough and none of the calculations are completely free from aberrations in doing so.

  • In such cases, the terminal value is one of the most useful tools to determine the future value of a business.

Therefore, it is a very important metric for both business owners and finance professionals.

raja
Published on 03-Dec-2021 10:59:35
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