In finance, several different methods are used to determine the value of a company. Some of them include the Discounted Cash Flow (DCF) method, the perpetuity growth method and the exit multiple approach. All three methods mentioned here have one particular financial concept in common — the terminal value.
So, what is the meaning of terminal value, why is it important, and where is it used? Continue reading to learn all about this concept.
Terminal value is a term used in valuation and financial modelling. It represents the value of a business or an investment at the end of a specific forecast period. Since the terminal value captures all of the future cash flows beyond the forecast period, it is a good indicator of the long-term earning potential of the business or investment.
Understanding terminal value
Now that you know what terminal value is, let us explore the concept in detail.
Companies often conduct feasibility studies before taking up a new project. This is done to determine whether the earnings from the project would be worthwhile for the company to pursue or not.
One of the most commonly used methods in feasibility studies is the Discounted Cash Flow (DCF) method. Companies adopting the DCF approach generally forecast (predict) the cash flows that the project is likely to generate in the future years. The typical forecasting period for the DCF method ranges between three and five years.
Since the forecasted cash flows represent the future, they are discounted to represent the present value using a discount rate. The present value of the future forecasted cash flows is then analysed to determine whether the project is feasible or not.
But then, what about after the forecasting period? How do companies determine the cash flows or the value of the project after the said period expires? Here is where the concept of terminal value comes into the picture.
By calculating the terminal value, companies can determine the value of the project at the end of the forecast period.
What are the different methods that are used to determine the terminal value
There are several methods to calculate the terminal value of a business or an investment. However, experts generally use either of two approaches - the perpetuity growth model or the exit multiple approach - to determine the value. Let us look at each of these approaches in more detail.
Perpetuity growth model
The perpetuity growth model assumes that the cash flows of a business or investment will grow at a constant rate forever beyond the forecast period. The formula that this method uses to calculate terminal value is as follows.
| Terminal Value = [Free Cash Flow (FCF) * (1 + Growth Rate)] ÷ (Discount Rate - Growth Rate) |
Here, Free Cash Flow represents the cash flow for the last 12 months of the forecast period. The growth rate, meanwhile, represents the rate at which the business or investment is expected to grow forever. The discount rate is the Weighted Average Cost of Capital (WACC).
Exit multiple approach
The exit multiple approach requires you to apply a multiple to the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) of the business or investment to determine its terminal value. The multiple used in this approach usually comes from peer companies or other similar transactions in the market. The formula you need to use to determine the terminal value as per this method is as follows.
| Terminal Value = Exit Multiple * EBITDA |
Here, EBITDA represents the collective Earnings Before Interest, Taxes, Depreciation and Amortisation for the last 12 months of the forecast period.
What does negative terminal value mean
Ideally, the value of a business or an investment beyond the forecast period must always be positive. However, in some cases, the terminal value may be negative. Understanding what it means is crucial and can help you make informed financial decisions.
A negative terminal value usually means that future cash flows are insufficient to recover the initial investment amount plus the expected returns. To put it simply, if a project has a negative terminal value, it would be a loss-making investment. In such cases, the company would be better off abandoning the project entirely.
What are some reasons for using terminal value
Terminal value is used for several crucial purposes. Here is a brief overview of some of the key reasons.
- To identify long-term potential
The terminal value of a business or an investment provides a comprehensive assessment of its future earning potential. For instance, if a project’s terminal value is positive and high, it means that it means that it has good long-term revenue generation potential. - To simplify valuation models
When valuing a business or an investment using a method like the discounted cash flow (DCF) approach, projecting cash flows indefinitely is impractical. Terminal value consolidates all future cash flows into a single terminal figure. This streamlines and simplifies the calculation process considerably. - To facilitate comparisons
By estimating the Terminal value for various investment opportunities, analysts can quickly assess their relative attractiveness and make informed decisions. - To enable corporate valuations
Financial analysts use terminal value during Mergers and Acquisitions (M&A) to determine the fair market value of a company and assess its acquisition or investment potential.
Conclusion
Terminal value is a crucial component of financial analysis. It is widely used by analysts in various financial models to gain insights into the long-term performance and profitability of a business or an investment.
If the terminal value is found to be negative, the business or investment is likely to be loss-making in the future. On the other hand, if the terminal value is positive, it may be indicative of strong long-term value creation potential.
