Terminal value calculation in uncertain markets

2 July 2024

In 2024, over 60 countries will be holding elections. Even for those countries not voting, there will be uncertainty about the outcome for the United States of America, United Kingdom, European Union countries and Australia. Valuations are grounded in risk, so uncertainty in key markets will be felt worldwide.

When calculating value, we can specifically forecast cash flows for several years, but a business still has value beyond that. A logical way to remember this is that after say five years, the business being valued could be sold at that time. Not only has it generated cash flows (hopefully) for those five years, but it then has a terminal value that is the exit value at the end of the forecast period.

In a Discounted Cash Flow valuation, the terminal value is a meaningful component of the total business value. In startups with limited near-term cash flows, most of the value is derived from the terminal value. In mature businesses, there’s a more even split.

Either way, despite the time value of money, understanding the terminal value is critical in getting to grips with the technicalities of valuations.

Why do we need a terminal value calculation in a valuation?

A terminal value isn’t nearly as macabre as it sounds. As already mentioned, this is a way of calculating ongoing value beyond what has been specifically forecasted.

There are a few reasons why calculating a terminal value is the right approach to take in a Discounted Cash Flow valuation:

  1. Forecasting accuracy is already a challenge and only gets worse as you look further into the future, leading to a rapidly diminishing benefit of detailed forecasts more than five years ahead.
  2. Businesses are assumed to be evergreen unless a specific project with an end-date is being valued, so it is reasonably to work in a terminal value as an estimate of what the business might be worth at a point in the future.
  3. Startups and turnaround stories will only generate most of their value towards the end of the specifically forecast period, leading to a material undervaluation of these opportunities unless a terminal value is considered.
  4. Using a modest terminal growth rate bakes in a level of conservatism in the valuation that avoids a scenario where the terminal value (the hardest value of all to forecast) is too high a component of the total valuation.
  5. Risk can be assessed based on an understanding of the extent of the valuation derived from near-term cash flows vs. the terminal value.

Typically, we would look at a forecast of around 5 years before calculating a terminal value. It’s possible to look at a longer horizon, but this is where we have the dual effect of uncertainty and the time value of money. Remember, a cash flow is more valuable the sooner it occurs.

How is a terminal value calculated?

The starting point to calculate a terminal value is to forecast the cash flow in the final year of the discounted cash flow. This requires a great deal of work to correctly model out the cash flow profile over say five years, leading to a reasonable approximation of free cash flow in year five.

Once that all-important number has been calculated, the common approach is to use a Gordon Growth Model to estimate the terminal value. This is based on the terminal growth rate (the growth into perpetuity of the cash flows) and the discount rate, which is the rate of return required by investors. The discount rate is estimated with reference to the risk in the business.

A higher discount rate means a lower terminal value. A higher terminal growth rate means a higher terminal value. The terminal value is extremely sensitive to these variables, which is one of the common criticisms of a Discounted Cash Flow approach.

Here comes the calculation (in simple language):

Terminal Value Calculation

There is another way that is particularly popular in a private equity context. At bizval, we also bring this type of thinking into our proprietary model by considering an exit value based on a reasonable exit multiple.

In such a case, the terminal value is simply the year five free cash flow multiplied by a reasonable free cash flow multiple to estimate what the company could be worth at that point in time. The major advantage here is that it is easier to understand an exit multiple than to debate the intricacies and sensitivities of a Gordon Growth Model.

How does uncertainty affect terminal value?

Uncertainty creates risk. Where there is more risk, the value of an asset decreases (all else being equal). In a terminal value calculation, higher risk can be represented by either an increased discount rate or a lower multiple.

Although an exit multiple approach is a simpler way to calculate a terminal value, the Gordon Growth Model shines in its ability to bring in the discount rate as a measure of risk. This allows for clarity on the risk being built into the model and whether it appears reasonable.

As the discount rate changes, it’s not just the terminal value that changes. The free cash flow over the specific forecast period will also change. This is why a Discounted Cash Flow is incredibly sensitive to the discount rate used in the model.

How do you calculate the terminal growth rate?

The terminal growth rate can be estimated based on past performance and expected future potential. It may be hard to predict growth in an uncertain market, but that’s where we can adjust the discount rate to reflect the risk of the cash flows. A general rule of thumb is that the terminal growth rate will be around the inflation rate, unless there is a specific reason otherwise. It is unwise to assume real growth (i.e. in excess of inflation) into perpetuity.

The conservative nature of the terminal growth rate is one of the arguments in favour of the exit multiple approach to calculate the terminal value. After all, what is the likelihood of the business only growing at inflation in year 6? If it is still fast-growing at that point, the terminal value using a Gordon Growth Model will undervalue the company.

How do you calculate the discount rate?

The discount rate is generally calculated by starting with a risk-free rate, which is typically the 10-year government bond yield for the region in which the company operates. Although this certainly isn’t a zero-risk rate, it’s the closest thing we can get to a risk-free rate in the region.

An equity risk premium must be added to this rate, as equity investments are riskier than buying government bonds. On top of this, there are various further adjustments required to reflect the risk in private companies vs. public and listed companies.

The quantum and nature of the risk premium over the risk-free rate will always be a hotly-contested point in a deal negotiation, specifically because of the sensitivity of the Discounted Cash Flow model to the discount rate.

The overall point to remember is that risk and reward must be balanced.

What about hyperinflationary environments?

If you are valuing a business in an environment with extremely high inflation, you will likely run into a few issues.

Inevitably, the risk-free rate in such markets is anything but risk-free, as the government is running out of money and watching its currency rapidly depreciate. This creates a need for earnings in the local currency to be growing at an extremely high rate just to match inflation. In many cases, businesses try to pivot into hard currency earnings, which is why the US Dollar is often the language of business in frontier markets that struggle with hyperinflation.

It’s also worth remembering that the discount rate needs to reflect the risk and must be higher than the terminal growth rate, otherwise the terminal value will show as negative.

In conclusion:

In a Discounted Cash Flow model, there are scientific methods to express the future cash flows as a value today. There’s also no shortage of art required not just in the business forecasts, but in the adjustments made to discount rates and terminal growth rates as well.

Regardless of the exact approach taken and the level of conservatism or aggression in the forecasts, a Discounted Cash Flow model must always take into account a terminal value. Not doing so would severely undervalue a company, unless there is a specific reason why cash flows should end at a particular point in time.

FAQs on Terminal Value Calculation in Uncertain Markets

1. Why is terminal value important in a Discounted Cash Flow (DCF) valuation?

Terminal value is crucial in a DCF valuation because it represents the ongoing value of a business beyond the explicitly forecasted period. This value can be a significant component of the total business valuation, especially for businesses with limited near-term cash flow. Without calculating the terminal value, a business could be severely undervalued.

2. How do you calculate the terminal value using the Gordon Growth Model?

To calculate the terminal value using the Gordon Growth Model, you start by forecasting the cash flow in the final year of the DCF model. Then, apply the following formula:

Terminal Value Calculation

This formula requires estimating the terminal growth rate and the discount rate, which reflect the growth into perpetuity of the cash flows and the rate of return required by investors, respectively.

3. What are the challenges of calculating terminal value in uncertain markets?

Uncertain markets introduce higher risk, which complicates the estimation of terminal value. The discount rate and terminal growth rate are highly sensitive to market conditions, and higher uncertainty typically leads to increased discount rates or lower multiples. This makes the terminal value calculation more complex and highlights the need for careful risk assessment and reasonable assumptions.

4. Why might an exit multiple be used instead of the Gordon Growth Model for terminal value calculation?

An exit multiple approach might be used instead of the Gordon Growth Model because it is simpler and often more understandable. In this method, the terminal value is calculated by multiplying the year five free cash flow by a reasonable free cash flow multiple. This approach is particularly popular in private equity contexts, providing a more intuitive estimation compared to the complexities and sensitivities involved in the Gordon Growth Model.

5. How does hyperinflation impact terminal value calculation?

In hyperinflationary environments, the risk-free rate is often unreliable due to government instability and currency depreciation. This requires businesses to have earnings that grow at a high rate just to keep pace with inflation. The discount rate must be higher than the terminal growth rate to avoid negative terminal values. Hyperinflation adds significant complexity to terminal value calculation, necessitating adjustments to reflect the heightened risk and economic conditions.

Case Study: Calculating Terminal Value in an Uncertain Market

Background: A rapidly growing tech startup, acrnym Inc., was looking to attract investors amidst uncertain market conditions. The company needed an accurate valuation to pitch to potential investors, considering that a significant component of its value is achieved 5+ years from now.

Challenge: Given the market uncertainty and limited near-term cash flows typical of startups, most of the value was expected to be derived from cash flow in future years. Accurately calculating this value amidst market volatility presents a challenge, requiring a robust methodology that considers long-term growth and fair risk assessment.

Approach:

  1. Forecasting Cash Flows: Cash flow forecasts were created for the next five years, projecting an exponential increase as acrnym Inc. scales its operations and market reach.
  2. Terminal Value: The Gordon Growth Model was used to calculate the terminal value. The terminal growth rate was aligned with inflation, reflecting a conservative long-term growth assumption once a reasonable level of market adoption had been reached. The discount rate was adjusted to reflect the increased market risk.
  3. Sensitivity Analysis: Recognising the model’s sensitivity to input variables, a sensitivity analysis was conducted, adjusting the terminal growth rate and discount rate to evaluate their impact on the valuation.

Outcome: The calculated terminal value provided an estimate of the long-term potential, even in an uncertain market. The valuation allowed the founders of acrnym Inc. to attract investor interest, through a fair analysis of cash flow which considers the inherent market risk.

Conclusion: By effectively utilising a terminal value, alongside a detailed 5-year forecast, and conducting sensitivity analyses, a fair valuation can be conducted even in an uncertain market. A fair and considered approach promoted investor confidence and potential for funding success.