Terminal Value

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 and formulas are used to calculate it. By the way, the easiest way to do it is to use our online accounting services.

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. Your bookkeeping virtual assistant can help you make sure the calculation of terminal value is done right and no deadlines get missed.

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 = (FCF_n ×(1 + g)) ÷ (WACC – g)

Where:

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.

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:

TV=EBITDA_n×(EV÷ EBITDA)

Where:

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

You don’t have to do your own calculations to find out the average and median EV and EBITDA of the industry. EBITDA multiples are published in market research journals from previous years. Screenshot from Deloitte Food and Beverage Update First quarter 2014

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:

1. Calculate the terminal value using the Gordon Growth Model.
2. Calculate the terminal value using the Terminal Multiple Approach.
3. Calculate the perpetuity growth rate based on the terminal value from p.2.
4. Calculate the terminal multiple based on the terminal value from p.1.
5. Compare the perpetuity growth rate used in p.1 and 3.
6. Compare 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.

Key takeaways

• 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.

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