Valuation | Terminal Value

The terminal value of a company is calculated at the end of the explicit forecast period in a discounted cash flow (DCF) valuation and represents the present value of all future cash flows when the company is assumed to grow at a stable rate indefinitely. This is a critical component of DCF as it often comprises a large portion of the total valuation. There are two primary methods used to calculate terminal value: the Perpetuity Growth Model (also known as the Gordon Growth Model) and the Exit Multiple Method.
1. Perpetuity Growth Model (Gordon Growth Model):This method assumes that the company will continue to generate cash flows at a constant rate forever. The formula for calculating terminal value using the Perpetuity Growth Model is:
Terminal Value=FCF×(1+g)/(r−g)​
Where:

• FCF = Free cash flow in the last forecast period.
• g = Stable growth rate (the rate at which free cash flows are expected to grow indefinitely).
• r = Discount rate (usually the weighted average cost of capital, WACC).

Key Considerations:

• The growth rate g should be conservative and typically not exceed the long-term growth rate of the economy or the industry.
• The growth rate should be less than the discount rate to ensure the formula works and the terminal value is finite.

2. Exit Multiple Method:This method involves applying a valuation multiple to a financial statistic of the company at the end of the forecast period. The most common multiples used are EV/EBITDA or P/E. The formula for calculating terminal value using the Exit Multiple Method is:
Terminal Value=Multiple×Financial MetricTerminal Value=Multiple×Financial Metric
Where:

• Multiple is the chosen valuation multiple (e.g., EV/EBITDA or P/E) based on industry standards, comparable companies, or historical averages.
• Financial Metric is the company's forecasted financial statistic (e.g., EBITDA or Earnings) at the end of the explicit forecast period.

Key Considerations:

• The chosen multiple should reflect the industry norms and the company's expected state at the end of the forecast period.
• This method is essentially a form of relative valuation and assumes that the company can be sold for a value similar to comparable companies.

Discounting the Terminal Value:Regardless of the method used to calculate the terminal value, it must be discounted back to its present value using the discount rate (WACC). This is done using the formula:
Present Value of Terminal Value=Terminal Value/(1+r)^n​
Where:

• n = Number of periods from the valuation date to the end of the forecast period.

Final Thoughts:

• Sensitivity Analysis: Given the terminal value's significant impact on the total valuation, it's often prudent to conduct a sensitivity analysis on key assumptions like the growth rate and the discount rate.
• Consistency and Reasonableness: Ensure that the assumptions used in the terminal value calculation are consistent with the broader economic and industry outlook and the company's competitive position.
• Professional Judgment: Calculating terminal value involves significant judgment, especially in selecting the appropriate growth rate and multiple. Analysts must consider all relevant factors and use their professional judgment to arrive at a reasonable estimate.

In summary, the terminal value is a crucial component of the DCF valuation, representing the present value of all future cash flows beyond the forecast period. It's calculated using either the Perpetuity Growth Model or the Exit Multiple Method, each with its considerations and assumptions. Given its substantial impact on the total valuation, it's essential to approach the terminal value calculation with care, reasonableness, and professional judgment.