In 2024, over 60 countries will be holding elections. Even for those countries that do not vote, there will be uncertainty about the outcome for the United States of America, the 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 also 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.
What Is Terminal Value (TV)?
The Terminal Value is the estimated worth of a company after the explicit forecast period in a DCF model. It typically makes up a significant portion of the total valuation in a DCF model. Therefore, the estimated value of a company’s free cash flows beyond the initial forecast must be reasonable for the valuation to be credible.
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:
Forecasting Accuracy
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.
Businesses are Assumed to be Evergreen
Businesses are assumed to be evergreen unless a specific project with an end-date is being valued, so it is reasonable to work in a terminal value as an estimate of what the business might be worth at a point in the future.
Startups and Turnaround Stories
Startups and turnaround stories will only generate most of their value towards the end of the specific forecast period, leading to a material undervaluation of these opportunities unless a terminal value is considered.
Using a Modest Terminal Growth Rate
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.
Risk can be Assessed
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 five 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.
Main Methods to Calculate Terminal Value
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.
Perpetuity Growth Method (Gordon Growth Method)
Discounting is needed because the time value of money causes differences between current and future values. In business valuation, free cash flow or dividends are forecasted for a set period, but estimating ongoing concerns becomes harder the further they are projected in to the future. Determining when a company might stop operations is also challenging. Investors often assume cash flows will grow at a steady rate indefinitely to overcome these limitations, starting at some future point. This assumption is known as the terminal value.
To calculate the terminal value, divide the last cash flow forecast by the difference between the discount and terminal growth rates. This calculation estimates the company’s value after the forecast period. Assuming cash flows grow at a constant rate forever, use the formula:
FCF / (d – g)
Where:
- FCF is the free cash flow for the last forecast period.
- g is the terminal growth rate.
- d is the discount rate, usually the weighted average cost of capital.
The terminal growth rate is the constant rate at which a company is expected to grow indefinitely, beginning at the end of the last forecasted cash flow period. It typically aligns with the long-term inflation rate but should not exceed the historical GDP growth rate.
No-Growth Perpetuity Method
The No-Growth Perpetuity Method is another way to calculate terminal value. This method assumes the business will generate consistent free cash flow indefinitely without growth.
To find the terminal value, use the formula:
FCF / d
Here, FCF is the free cash flow of the last forecast period, and d is the discount rate.
This approach is simple and suitable for businesses expected to have stable and predictable cash flows over time.
Exit Multiple Approach or Method
There’s no need for the perpetuity growth model if investors believe operations have a limited time frame. Instead, the terminal value should reflect the net realizable value of a company’s assets. This often suggests that a larger firm will acquire the equity, and acquisition values are usually calculated with exit multiples.
Exit multiples determine a fair price by multiplying financial metrics, such as sales or EBITDA, by a common factor for recently acquired similar firms.
The terminal value formula using the exit multiple method involves taking the most recent metric like sales or EBITDA and multiplying it by the chosen multiple, usually an average from recent transactions.
Investment banks often use this valuation method, though some critics are hesitant to mix intrinsic and relative valuation techniques.
DCF Terminal Value Implied Growth Rate Formula
The perpetuity growth approach should be used alongside the exit multiple approach to verify the implied exit multiple and vice versa. Each method checks the other’s accuracy. Both calculations are usually shown side by side unless there are time constraints or a lack of data. If the implied perpetuity growth rate from the exit multiple seems too low or high, assumptions may need adjusting.
Implied Exit Multiple = Unadjusted TV ÷ Final Year EBITDA
When calculating TV using the exit multiple approach, verify the amount by determining an implied growth rate to ensure it’s reasonable. The terminal value under either approach should be closed. The exit multiple approach is often preferred because it is easier to justify assumptions. The DCF analysis method is meant for intrinsic, cash-flow-based valuation.
Implied Growth Rate = (Discount Rate – Terminal Value ÷ Final Year FCF) ÷ (1 + Terminal Value ÷ Final Year FCF)
Present Value of Terminal Value (PV)
A perpetuity is a security like a bond with no fixed end date. To calculate its present value, divide the cash flow by the discount rate. For example, if the cash flow is $100 and the discount rate is 10%, the present value is $1,000 ($100 ÷ 10%).
The perpetuity growth method assumes constant cash flow growth. This means the formula must adjust for growth by subtracting it from the discount rate. If the cash flow is $100, the discount rate is 10%, and the growth rate is 3%, the terminal value is about $1,471.
Terminal Value = ([$100 x (1 + 3.0%)] ÷ [10.0% – 3.0%]) = ~$1,471.
Where is the Terminal Growth Rate Used?
Beyond valuations, the Terminal Growth Rate is used in finance and business decision-making. Key uses include:
Investment Decisions
Investors use the Terminal Growth Rate to assess a company’s long-term growth potential. A higher rate can indicate a more appealing investment.
Strategic Planning
Companies use the Terminal Growth Rate to set realistic long-term financial goals. It helps them evaluate the sustainability of their competitive advantage.
Budgeting and Financial Forecasting
The Terminal Growth Rate helps companies estimate future cash flows. It is used for making financial forecasts and budgets.
Dividend Policy
For mature companies with stable cash flows, the Terminal Growth Rate guides appropriate dividend policies. This rate indicates how sustainably dividends can grow.
Mergers and Acquisitions
In merger and acquisition analyses, the Terminal Growth Rate helps estimate future cash flows. It also assesses the potential synergies of the combined entity.
Cost of Equity and Capital
The Terminal Growth Rate helps calculate equity cost in the Dividend Discount Model (DDM). It also determines the capital cost in the Weighted Average Cost of Capital (WACC) formula.
Credit Risk Assessment
Credit rating agencies and lenders often look at the Terminal Growth Rate to evaluate a company’s long-term creditworthiness. This helps determine if the company can meet its debt obligations.
Scenario Analysis
The Terminal Growth Rate is used to analyze different growth rate assumptions. It helps assess their impact on a company’s value and performance.
Industry-Specific Considerations
Industries have different Terminal Growth Rates based on growth potential, market maturity, and risk. The technology sector, with rapid advancements, may see higher growth rates. Mature industries might experience lower growth rates.
Growth Potential
Industries like technology, renewable energy, and healthcare can have higher Terminal Growth Rates. This is due to new opportunities and rising demand for their products or services.
Market Maturity
Mature industries, such as utilities or traditional consumer goods, usually have lower Terminal Growth Rates. These industries often grow slowly as they reach market saturation.
Risk Profiles
Industries with higher risks, like biotechnology or startups in competitive markets, might have lower Terminal Growth Rates. This is because investors expect higher returns to offset the uncertainty.
Execution Failures in Growth Projections
It’s vital to project growth using past successes and industry standards, but you must also consider potential failures. These could arise from market changes, internal issues, or external pressures. Relying only on historical growth may result in an overly optimistic Terminal Value. It’s important to adjust the Terminal Growth Rate or Terminal Value to account for possible failures.
Assumptions of the Terminal Growth Rate
The Terminal Growth Rate calculation relies on a few key assumptions. It assumes the company will experience steady and sustainable growth after the forecast period. It also assumes the company will keep its competitive edge and that market conditions will stay stable.
Steady and Sustainable Growth
The Terminal Growth Rate assumes the company will grow steadily after the forecast period. This means the company will keep expanding and generating more cash flow without major disruptions or negative events.
Competitive Advantage
The Terminal Growth Rate relies on the company’s ability to keep its competitive advantage. This advantage can come from unique products, innovative technologies, strong brand recognition, or cost leadership. If the company loses this edge, the Terminal Growth Rate might not apply, and growth prospects could change.
Stable Market Conditions
The Terminal Growth Rate calculation assumes stable market and economic conditions over the long term. Economic changes, consumer preference shifts, technological changes, or disruptive market forces could affect a company’s growth potential.
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 must reflect the risk and be higher than the terminal growth rate; otherwise, the terminal value will be unfavorable.
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.
FAQs
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.
What does a negative terminal value mean?
A negative terminal value in a business can mean a few things: The business is unprofitable with no expected recovery, the perpetual growth rate is higher than the discount rate, or there are errors in the cash flow forecasts.
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.
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.
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.