Meaning Of Terminal Value
The value of an investment at the end of a forecast period is referred to as the terminal value. When constructing a discounted cash flow model, terminal value (also known as TV) is frequently estimated as a way of accounting for the value of the firm at the end of the forecast investment period or the time span over which a more precise valuation can be measured. The value of a business or investment is equal to the present value of the expected future cash flows from the business or investment. An investor or analyst will need to estimate those future cash flows in order to determine the value of the company because we cannot predict the future and therefore cannot know their exact amount with certainty.
When conducting discounted cash-flow analysis, it is critical to understand that, while an investor may be confident in projecting expected cash flows for several years into the future, the further off those projections are from the present, the less inherently accurate they become.
This is not unique to the financial sector. Consider the following scenario for an easy-to-follow illustration: a weather forecast. A rain forecast for three days in the future is generally considered to be fairly accurate. Rain forecasting three months in the future is much more difficult to do.
We must address the inability to predict future cash flows, because the present value of an investment is equal to the sum of all expected future cash flows at the time of its inception.
As a fundamental investor, you can account for this discrepancy by first estimating a value over the time period for which you are confident in your ability to accurately assess cash flows, and then using a more generalized approach to estimate the remaining, or terminal, value of the investment.
It would be necessary to estimate the value of an investment for a given period using a valuation technique such as the discounted cash flow model, which would be the first step in this process. In order to estimate the terminal value at the end of that time period, the following step would be taken.
The total value of the investment is equal to the sum of the values of the two estimations made earlier.
Terminal value calculation methods
Terminal multiple method:
The terminal multiple method, also known as the exit multiple method, is based on the assumption of a finite window of operations. Therefore, the terminal value will need to accurately reflect the net realizable value of the business's assets at the time of valuation. When applying the terminal multiple method to a business, the assumption is made that the company will be sold at the end of the projection period. A statistic (the terminal multiple) such as EBITDA will be multiplied by a projected statistic such as sales to complete this terminal value calculation (i.e., the relevant statistic projected in the previous year). According to the terminal value formula for the terminal multiple method, the following is true:
Terminal Value = Terminal Multiple from Last 12 Months x Projected Statistic
Perpetuity growth model:
The perpetuity growth model, in contrast to the terminal multiple method, assumes that the cash flow values of your company will continue to grow at a steady rate indefinitely. To do so, divide the most recent cash flow forecast by the difference between the terminal growth rate and the discount rate, and multiply the result by 100. The following is the formula for calculating the terminal value of the perpetuity growth model:
Terminal Value = (Free Cash Flow x (1+g)) / (WACC – g)
Free Cash Flow = FCF from the last 12 months
WACC = Weighted Average Cost of Capital
g = Perpetuity growth rate
Disadvantages Of Using A Terminal Value
It is important to note that there are some limitations to both of the terminal value formulas discussed above: If you are using the terminal multiple method, it is important to remember that terminal multiples are dynamic and can change at any given time. When it comes to the perpetuity growth model, it is difficult to predict the rate of growth with any accuracy. While at the same time, any assumed values that are used in the formula can cause errors in your terminal value calculation.
Of course, these limitations do not rule out terminal value as a useful metric in certain situations. It is clear from their findings, however, that it is necessary to employ a wide range of multiples and applicable rates in order to ensure that you obtain an acceptable result.