What Is Terminal Value (TV)?

What Is Terminal Value (TV)?

Let me explain terminal value directly: it's the value of a company beyond the period where we can reliably estimate future cash flows. You assume the business grows at a steady rate forever after that forecast, which is usually five years or less. This terminal value often represents a big chunk of the total value we assign to a business. You can also apply it to assets or projects.

Understanding Terminal Value

As the time horizon stretches out, forecasting gets murkier, especially for a company's cash flows far into the future. But we still need to value businesses, so analysts like me use models such as discounted cash flow (DCF) along with assumptions to figure out the total value of a business or project. DCF is a go-to method for feasibility studies, acquisitions, and stock valuations. It's based on the idea that an asset's value comes from all its future cash flows, discounted back to present value using a rate that reflects the cost of capital, like an interest rate.

In DCF, there are two main parts: the forecast period and the terminal value. We typically forecast for three to five years because longer periods reduce accuracy. That's where terminal value steps in. For some industries, like natural resource extraction, this period might be longer. The common methods are perpetual growth, or the Gordon Growth Model, which assumes constant cash flow generation forever, and exit multiple, which assumes the business gets sold. Investment pros often prefer the exit multiple, while academics lean toward perpetual growth.

How Is Terminal Value Estimated?

You estimate terminal value using formulas that project future cash flows to present value, much like in DCF analysis. The liquidation value or exit method involves calculating the asset's earning power with a discount rate, then adjusting for outstanding debt. The stable growth model assumes the company reinvests cash flows and grows at a constant rate forever, without liquidation. The multiples approach takes the company's sales revenues from the last year of the DCF model and multiplies by a factor from similar firms, without extra discounting.

Types of Terminal Value

Let's break down the types. First, the perpetuity method: Discounting accounts for the time value of money, creating differences between current and future values. In business valuation, you can forecast free cash flow or dividends for a set period, but longer projections get tricky, and it's hard to predict when a company stops operating. To handle this, assume cash flows grow at a stable rate forever from some point—that's your terminal value. Calculate it by dividing the last forecast cash flow by the difference between the discount rate and terminal growth rate. The formula is FCF / (d – g), where FCF is free cash flow for the last period, g is the terminal growth rate (usually aligned with long-term inflation, not exceeding historical GDP growth), and d is the discount rate, often the weighted average cost of capital.

Then there's the exit multiple method: If you assume operations end after a finite period, terminal value reflects the net realizable value of assets then, often implying acquisition by a larger firm. Use exit multiples by multiplying financial stats like sales, profits, or EBITDA by a common factor from recent similar acquisitions. The formula is the most recent metric times the chosen multiple, averaged from other transactions. Some hesitate to mix this with intrinsic valuation, but investment banks use it often.

Terminal Value vs. Net Present Value

Don't confuse terminal value with net present value (NPV). Terminal value is used in DCF and depreciation to capture an asset's value at the end of its life or a business beyond projections. NPV, on the other hand, measures if an investment or project will be profitable by discounting all future cash flows to present value and subtracting the initial cost. It's a key tool for deciding on investments because it factors in the time value of money.

Why Do We Need to Know the Terminal Value of a Business or Asset?

Companies don't plan to shut down after a few years; they aim to operate indefinitely. Terminal value lets you anticipate that future value and discount it to today's prices.

Should I Use the Perpetuity Growth Model or the Exit Approach?

Neither method gives a perfect estimate. Choose based on whether you want an optimistic or conservative figure—the perpetuity model usually gives a higher value. You can use both and average them for a final NPV estimate.

What Does a Negative Terminal Value Mean?

A negative terminal value occurs if future capital costs exceed the growth rate, but in reality, it can't persist long. Equity value bottoms at zero, and liabilities get handled in bankruptcy. If you see negative earnings relative to cost of capital, look to other tools beyond terminal valuation.

The Bottom Line

Terminal value is the estimated value of an asset at the end of its useful life, key for depreciation and a major part of DCF because it covers much of a business's total value. Calculate it via perpetual growth or exit multiple, but scrutinize your assumptions—they heavily affect the valuation.