The terminal value is all the money a company will make in the future beyond a certain forecast period. It is a part of the discounted cash flow (DCF) analysis that helps to determine the present value of the company based on its future cash flow.
The terminal value is a major part of the total value of a company. It’s more than 60%.
Let’s find out why the terminal value is important, what methods are used to calculate it and what formulas are used.
Why does a company need to calculate its terminal value?
Usually, the forecast period for a company is 5 years or less. For this period, one can make detailed assumptions about the business’s growth. Beyond that period, it gets difficult to predict future cash flow or how many dividends the company will pay out by using the same financial models.
And that’s why financial analysts developed the concept of terminal value as a way to forecast the future value of a company.
How to calculate the terminal value?
There are two main methods to calculate terminal value. Both are based on different analytical approaches, assumptions and various financial statistics but aimed at the same result. Let’s take a closer look at the description of the methods and their formulas:
The Perpetuity Growth Method (aka The Gordon Growth Model)
This method is based on the assumption that the business will grow perpetually at a constant rate after the estimated period, e.g. after 5 projected years. At the same time, it is difficult to predict an accurate growth rate and its stability because the market situation and the economy itself might change for the worse.
The method seems to be more suitable for companies with a stable position on the market, like FMCG businesses, or for academic use.
Under the Gordon Growth Model, the terminal value is calculated according to the following formula:
TV = (FCFn ×(1 + g)) ÷ (WACC – g)
TV — the terminal value
FCF — free cash flow
n — a period of time, usually the last year
g — the perpetuity growth rate
WACC — the weighted-average cost of capital, or in other words, the cost of the company’s fund or the rate of return on the company's securities.
Perpetuity growth rate usually depends on inflation and the gross domestic product (GDP) rate and doesn’t exceed the economy’s growth rate *
So, it might be up to 3% in the UK. If you use a higher rate, then you assume that the company will grow faster than the economy as a whole.
Jane is a financial analyst. She is calculating the terminal value of a chocolate manufacturer Browny PLC. She assumes that the company is stable and expects it to grow consistently in the future. She uses a 1,5% growth rate based on the inflation rate of 1,8% and 1,4% GDP rate in 2019. WACC is 3% and free cash flow for the last year is £50.000. Jane calculates the terminal value as the following:
(50.000×(1+0,015))÷(0,03 – 0,015)=3.383.333
Now Jane knows that the company’s value will be about £3.383.333 in the future and can set a fair price for investors.
To get a more accurate forecast, one can apply a multiple-stage terminal value. This implies dividing the terminal value into several parts with a different growth rate, e.g. 3% for the first 5 years and 1,5% afterwards.
In any case, you should remember that it is too optimistic to expect cash flow to grow forever.
The Terminal Multiple Approach (aka the Exit Multiple Method)
This approach is based on the assumption that the value of the business at the end of a projected year depends on the existing public market valuations. It means that a company takes financial statistics of similar companies in the industry as an example for their own calculations.
In this method, the terminal value is calculated by multiplying the common financial statics like EBITDA, EBIT or Gross Profit of the company by a terminal multiple for similar companies in the industry:
TV = Statistics for the last year of a projected period × Terminal multiple
The terminal multiple is any financial multiple that reflects the company’s value. For example:
- enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA);
- enterprise value to revenue (EV/Revenue);
- enterprise value to gross profit (EV/Gross Profit).
Now let’s see how the terminal value formula transforms when we use the EBITDA multiple, which is the most common metric:
EBITDA — earnings before interest, taxes, depreciation and amortization of the company
n — the final year of the projected period
EV — enterprise value of similar companies in the industry, which means the sum of market capitalization, preferred shares, minority shares, and debt minus cash
EBITDA — earnings before interest, taxes, depreciation and amortization of similar companies in the industry
Say, Jane doesn’t believe that Browny PLC will have constant growth and limits the projection period to the year 2027. She researches financial statements of the company’s competitors and learns that the average EBITDA multiple is 13x. She expects the EBITDA of the company to be £280.000 in 2027.
Jane calculated the terminal value to be £3.640.000 which is close to the amount that she got using the Gordon Growth Model.
For cyclical businesses like real estate, tourism, construction machinery or metal production, the earnings fluctuate each year according to variations in the economy. So, instead of using the EBITDA amount at the end of a specific year, you should apply an average EBITDA throughout the cycle.
How to check calculations?
While you may apply only one of the methods to calculate the terminal value, it is reasonable to use both of them to cross-check your results.
To get reliable data, follow these steps:
- Сalculate the terminal value using the Gordon Growth Model.
- Сalculate the terminal value using the Terminal Multiple Approach.
- Сalculate the perpetuity growth rate based on the terminal value from p.2.
- Сalculate the terminal multiple based on the terminal value from p.1.
- Сompare the perpetuity growth rate used in p.1 and 3.
- Сompare the terminal multiple you used in p.2 and 4.
If the results of both methods are vastly different, you probably made a mistake in your calculations: either the perpetuity growth rate or the terminal multiple is incorrect.
Jane calculated the terminal value using both methods and got similar results. It means that she chose the growth rate and the multiple correctly. The truth lies in the middle between the two amounts that she calculated. The average terminal value of Browny PLC is about £3.511.667.
- The terminal value is the expected value of the company based on its future cash flow.
- The Perpetuity Growth Method is based on the assumption that the company is stable and will grow forever.
- The Terminal Multiple Approach is more realistic and is based on the assumption that the company has a defined projection period and its value depends on the existing public market valuations.
- Use both calculation methods to cross-check results.
* To learn why perpetuity growth rate doesn’t usually exceed the economy’s growth rate, see Terminal Growth Rate at CFI website