Investors need a mechanism like terminal value for determining these future revenue streams because it provides them with a more holistic view of how much the opportunity may be worth. Hence, this will have an impact on how much its valuation may be and what they are willing to pay for it.
How is Terminal Value Used?
One of the most used scenarios for terminal value is when one company decides it's going to buy another one. Before doing this, it has to assign a value to the prospective business by first estimating its expected future cash flows (FCFs).
Of course, since there is a time value component to money, this analysis has to be done by converting the value of dollars in the future into the value of a dollar today. Business analysts will do this using a process called discounted cash flow (DCF).
The value of thisprospective business may be divided into two parts:
- How much earnings the company will generate in the short-term (generally the first 3 to 5 years)
- How much earnings the company will generate afterward
Cash flows contributing to the initial stage of DCF are called the forecast period. During this time, its fairly well anticipated how much the company expects to make in revenue, what it will spend on operations, etc. Therefore, the analysts can make educated predictions about how much earnings the business will produce with a reasonable degree of confidence.
However, after approximately 5 years, making these types of predictions becomes more challenging. Demand for the products may change and operational costs may change.
Yet, we know that the business will not shut down. The business will continue to generate future cash flows in some shape or form. In fact, it’s been estimated that these future earnings will contribute approximately three-quarters of the total implied valuation of the company. Therefore, they must still be included in the DCF model in some shape or form.
Hence, analysts will do this by calculating what’s called the terminal value. The business’s terminal value will be the estimated sum of the company’s free cash flows (FCFs) beyond the initial forecast stage.
There are two commonly used methods that analysts follow to estimate a company’s terminal value: the perpetuity method and the exit multiple method.
Calculation Method No. 1 - Perpetuity Method
Again, since no one can see into the future, it's impossible to know for sure how much earnings a company will produce. However, we can reasonably assume that at some point years from now that it will achieve a so-called steady state.
In other words, the business will mature to the point where it produces a modest growth rate that the company should be able to achieve theoretically forever. If this rate can be estimated, then we can find the terminal value and add it back into our DCF calculation.
This method is sometimes also referred to as the Gordon Growth Model because it was originally published by Professor Myron J. Gordon. Although his analysis was used to value the price of a stock based on the sum of all of its future dividend payments, the same approach can be used for the valuation of companies too.
Using the perpetuity method, the terminal value can be found using the following equation:
TV = [ FCFn x (1 + g) ] / (WACC – g)
- FCFn = Free cash flow for the last forecast period “n”
- g = The expected growth rate of the asset in perpetuity per annum. For most companies, analysts will stick to a value that does not exceed the country’s GDP (generally less than 3 percent).
- WACC = The weighted average cost of capital is commonly used to determine the required rate of return (RRR) because its the rate that both shareholders and bondholders need for the company to have capital.
Suppose the company you work for wants to expand by purchasing another business. Before calculating TV, you determine the following about the business in question:
- Forecasted free cash flow = $10,000,000
- Growth rate = 2.0% or 0.02
- Discount rate = 10% or 0.10
TV = [ $10,000,000 x (1.02) ] / (0.10 – 0.02) = $127,500,000
This means that the future value of the company (in today's dollars) is $127,500,000.
Calculation Method No. 2 - Exit Multiple
Rather than assuming an investment will be held forever, another way that business leaders can determine a prospective company’s value is to calculate it as if it will be eventually sold. This is not uncommon in the business world when venture capital firms will buy a company with the aim of making it more profitable and then selling it after a few years.
Under this methodology, the terminal value simply has to reflect the realizable value of the acquired company's assets. Exit multiples may then also be applied.
In this method, instead of using FCF, we use EBITDA - net income with interest, taxes, depreciation, and amortization added back. The terminal value is calculated by simply taking the discounted EBITDA at the end of the forecast period and multiplying it by a multiple based on the EV of the industry.
Using the same values as the previous example, suppose the EBITDA is $20,000,000 and the EV/EBITDA multiple is 6.00x.
In this case, the terminal value is:
TV = $20,000,000 x 6 = $120,000,000
Notice that this value is relatively close to the perpetuity method. When done correctly with reasonable assumptions, these two estimates should produce similar results.
Terminal value is a method for determining how much earnings an asset will produce beyond the initial forecast period. This value is then used in conjunction with the discounted cash flow to determine its total valuation.
Business analysts have two commonly used methods that they use for finding a company’s terminal value: the perpetuity method and the exit multiple method. When done with proper assumptions, both calculations should produce relatively similar results.