In finance, the terminal value of a security is the present value at a future point in
time of all future cash flows when we expect stable growth rate forever. It is most often
used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow
projections to a several-year period. Forecasting results beyond such a period is impractical
and exposes such projections to a variety of risks limiting their validity, primarily
the great uncertainty involved in predicting industry and macroeconomic conditions beyond
a few years. Thus, the terminal value allows for the inclusion
of the value of future cash flows occurring beyond a several-year projection period while
satisfactorily mitigating many of the problems of valuing such cash flows. The terminal value
is calculated in accordance with a stream of projected future free cash flows in discounted
cash flow analysis. For whole-company valuation purposes, there are two methodologies used
to calculate the Terminal Value.
Perpetuity Growth Model See: Gordon Growth Model
The Perpetuity Growth Model accounts for the value of free cash flows, AKA the mother of
valuations, that continue into perpetuity in the future, growing at an assumed constant
rate. Also, the projected free cash flow in the first year beyond the projection horizon
is used. This value is divided by the discount rate minus the assumed perpetuity growth rate:
T0 = FCFN+1/(k – g). T0 is the value of future cash flows at a future point in time
which is immediately prior to N+1, or at the end of period N, which is the final year in
the projection period, k being the discount rate and g being the growth rate. This equation
is a perpetuity, which uses a geometric series to determine the value of a series of growing
future cash flows. To determine the present value of the terminal
value, one must discount the Terminal Value at T0 by a factor equal to the number of years
included in the initial projection period. If N is the 5th and final year in this period,
then the Terminal Value is divided by5. The Present Value of the Terminal Value is then
added to the PV of the free cash flows in the projection period to arrive at an implied
enterprise value. If the growth rate in perpetuity is not constant,
a multiple-stage terminal value is calculated. The terminal growth rate can be negative,
if the company in question is assumed to disappear in the future.
Exit Multiple Approach See: Valuation using multiples; Relative valuation.
The Exit or Terminal Multiple Approach assumes a business will be sold at the end of the
projection period. Valuation analytics are determined for various operating statistics
using comparable acquisitions. A frequently used terminal multiple is Enterprise Value/EBITDA
or EV/EBITDA. The analysis of comparable acquisitions will indicate an appropriate range of multiples
to use. The multiple is then applied to the projected EBITDA in Year N, which is the final
year in the projection period. This provides a future value at the end of Year N. The terminal
value is then discounted using a factor equal to the number of years in the projection period.
If N is the 5th and final year in this period, then the Terminal Value is divided by5. The
Present Value of the Terminal Value is then added to the PV of the free cash flows in
the projection period to arrive at an implied Enterprise Value. Note that if publicly traded
comparable company multiples must be used, the resulting implied enterprise value will
not reflect a control premium. Depending on the purposes of the valuation, this may not
provide an appropriate reference range. Comparison of Methodologies
There are several important differences between the two approaches.
The Perpetuity Growth Model has several inherent characteristics that make it intellectually
challenging. Because both the discount rate and growth rate are assumptions, inaccuracies
in one or both inputs can provide an improper value. The difference between the two values
in the denominator determines the terminal value, and even with appropriate values for
both, the denominator may result in a multiplying effect that does not estimate an accurate
terminal value. Also, the perpetuity growth rate assumes that free cash flow will continue
to grow at a constant rate into perpetuity. Consider that a perpetuity growth rate exceeding
the annualized growth of the S&P 500 and/or the U.S. GDP implies that the company's cash
flow will outpace and eventually absorb these rather large values. Perhaps the greatest
disadvantage to the Perpetuity Growth Model is that it lacks the market-driven analytics
employed in the Exit Multiple Approach. Such analytics result in a terminal value based
on operating statistics present in a proven market for similar transactions. This provides
a certain level of confidence that the valuation accurately depicts how the market would value
the company in reality. On the other hand the Exit Multiple approach
must be used carefully, because multiples change over time. Simply applying the current
market multiple ignores the possibility that current multiples may be high or low by historical
standards. In addition, it is important to note that at a given discount rate, any exit
multiple implies a terminal growth rate and conversely any terminal growth rate implies
an exit multiple. When using the Exit Multiple approach it is often helpful to calculate
the implied terminal growth rate, because a multiple that may appear reasonable at first
glance can actually imply a terminal growth rate that is unrealistic.
In practice, academics tend to use the Perpetuity Growth Model, while investment bankers favor
the Exit Multiple approach. Ultimately, these methods are two different ways of saying the
same thing. For both terminal value approaches, it is essential to use a range of appropriate
discount rates, exit multiples and perpetuity growth rates in order to establish a functional
valuation range. See also
Asset retirement obligation Business valuation
Cost of capital Future value
Geometric series Net present value
Perpetuity Terminal value
External Links and references Closure in Valuation: Estimating Terminal
Value, Prof. Aswath Damodaran, Stern School of Business