When we say “terminal value”, we mean the current business worth beyond the explicit period of the forecast. Also known as TV, the terminal value appears to be a crucial part of various financial tools. They include residual earnings computation, the Gordon Growth Model, and some more. Moreover, investors often use TV when they need to analyze discounted cash flow.
In this article, we will clarify the terminal value definition. Additionally, we will review several methods to calculate it using major formulas.
TV mainly refers to financial analysis. To understand the terminal value definition, we need to think of it as a total value of future cash flows outside the given projection time frame. The main mission is to let investors capture values that are difficult to capture using traditional models and financial forecast approaches.
Generally, you can use two different TV modalities. Selecting the one will totally depend on the type of analysis you need to perform:
The second option is the major choice among academics who admire the mathematical theory that supports this particular modality. At the same time, it does not guarantee the provision of an accurate perpetual growth rate, making the approach a bit complex to implement.
Now, let’s have a closer look at each approach and find out how to use them to calculate the terminal value.
When we say “exit multiple methods”, we consider the following TV calculation:
TV = Projected Stats x 12-months Exit Multiple
Under the existing multiple experts generally understand such components as EBIT, EBITDA, and other usual multiples that refer to enterprise values. They are used to research the financial value of the company. As for projected stats, they refer to relevant data and statistics generated from the previous year.
If you rely more on an academic approach with the mathematical theory behind the model the following calculation will meet your needs:
TV = (Free Cash Flow x (1 + g)) / (WACC – g)
In this formula, we can see the following components: last 12-months FCF (free cash flow), Weighted Average Cost of Capital (WACC), and sustainable (perpetual) growth rate (g).
Usually, the “g” component is lower than the growth rate of the economy. What’s more, it is equal to the inflation rate, which is very important to consider when using this particular formula and methodology.
As we have already stated, those who opt for the model of perpetuity growth will definitely face specific difficulties due to the methodology limitation, especially in terms of the accurate growth prediction. Besides, the results of TV calculations can be inaccurate.
On the other hand, the method of exit multiple also has specific downsides. The most crucial one results in the limitations of the multiples’ dynamic nature. They tend to change over some time making the calculation model implementation quite difficult.
Before you decide on the method to apply, you need to carefully consider all factors. NO matter what you choose, both approaches can be quite effective when getting an acceptable variant despite some obvious limitations and complexity.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.