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What is Terminal Value of a new business and how is it calculated?
Terminal Value (TV) is the value of an investment after the end of its initial forecast period. It is often estimated in the discounted cash flow (DCF) method as a way to account for the value of the firm after the end of its initial forecast period.
The value of a firm is its present value of the estimated future cash flows. To determine the terminal value, an analyst would need to estimate the future cash flows. Due to the inability of forecasting the future, the future values cannot be known with complete certainty.
The further the forecasts, the less inherently correct they become. In other words, the later the forecasts in the future, the harder it is to assume or calculate the terminal value.
The future values of all cash flows need to be addressed because the value of an investment is the present value of all those future cash flows. An investor or analyst can calculate the gap by estimating the value over a certain period and then using a more generalized approach for the remaining or terminal value.
The first step of the process would be to calculate the value of an investment for the given period by using a valuation technique such as discounted cash flow and then estimate the terminal value at the end of the period.
Methods to Calculate the Terminal Value
There are primarily three methods of calculating the terminal value, namely,
Liquidation Value Method,
Multiple Approach Method, and
Stable Growth Model
Let us discuss these three methods in detail.
Liquidation Value Method
The liquidation value method assumes that a firm will not run forever but will be closed and sold at some time in the future. The estimated net sale value of the firm will be its terminal value.
The liquidation value method is of two types and both focus on the assets of the firm.
The first method assumes that the assets can be sold at their inflationadjusted book value.
The second method assumes that the assets still have the potential to generate some value or a certain amount of cash flow which is discounted to the present value at the time of liquidation.
The formula for liquidation value is −
$$\mathrm{\text{Expected LV} = \text{BV of Assets in the Terminal Year} \text{(1 + IR)} ^{\text{Avg. life of assets}}}$$
Where,
LV = Liquidation Value
BV = Book Value
IR = Inflation Rate
Multiple Approach Method
The multiple approach model is based on the assumption that the business could be sold at a value that is multiple of some chosen fundamental measure of value such as net income or revenues. The chosen fundamental is selected depending on the value of similar other businesses at the given period of sale of the company.
The formula for multiple approach method is −
$$\text{TV = Financial Metric (e.g., EBITDA) × Trading Multiple (e.g.,10x)}$$
Stable Growth Model
The stable growth model assumes that the business continues the operation and grows at a certain rate beyond the investment period and reinvested. In this method, the value of estimated cash flows is discounted to the initial investment period.
The formula for stable growth model is −
$$\mathrm{Terminal\:value=\frac{Cash\:Flow\:in\:the\:Next\:Period}{(Discount\:Rate - Stable\:Growth\:Rate)}}$$
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