The terminal value of an organisation or security is an important tool that helps business owners estimate its future value. Understanding terminal value calculations enable businesses to attract investors and strategize with respect to business growth.
Let’s take a closer look at the concept of ‘terminal value’, including its benefits and limitations, formula, calculations, example, benefits and limitations. Read on!
The terminal value of a company helps assess its current value on the basis of its future value prediction. Analysts rely on a discounted cash flow model to evaluate the total value of a company. The forecast period and terminal value are important components of a discounted cash flow model.
For instance, if the stock prices of a company are very low, the current value may seem low. In such cases, the terminal value makes it possible to estimate the potential for growth and future value of the company. This, however, is only a prediction, and the current value can increase based on the expectation of the market regarding the company’s future.
Terminal cash flow can be derived based on the present cash flow. This will also allow the discounted cash flow (DCF) to be calculated. The assumption behind the DCF is that the value of the company is the sum of all future free cash flows that are discounted to the current day to reflect the “time value of money”.
The terminal value calculation for a business can be done in two main ways. Both these ways are based on current trends, and help predict the future value of a business.
The two main methods to calculate the terminal value are:
This method is also known by various other names, such as the perpetual growth or Gordon growth model. It is based on the assumption that the business will grow at a consistent rate in the future. It is based on a mathematical theory and is the preferred method of calculation for analysts. It also assumes that the cash flows are reinvested into the company, enabling the company to continue to grow at the same rate.
Here is how this method determines the terminal value:
The stable growth terminal value calculation requires the company’s FCF during the final 12 months of the current forecast duration. The FCF is then multiplied by the sum of the stable growth rate (S) and 1. This gives us the first part of the equation:
FCF * (S + 1)
The discount rate is calculated; this is usually taken to be the weighted average cost of capital (WACC), which is what we will consider here. Then, the stable growth rate is subtracted from it. This yields the subformula:
WACC – S
Terminal value = (FCF * [S + 1]) / (WACC – S)
Suppose the free cash flow of a business is Rs. 4,00,00,000 and the stable growth rate and the weighted average cost of capital are 5% and 8% respectively. Here is the terminal value calculation for the business based on the formula given above:
This method is also called the terminal multiple model. It predicts the value of a company assuming that another company will acquire it. It doesn’t assume indefinite growth but determines the value of the company at the time its ownership changes hands. This is a more popular method among investors because industry professionals prefer comparing the value of a business to the observations they can draw from the market. Some analysts also use both terminal value calculation methods and regard the real value as the average of the values from both methods.
Here is how this method works:
The terminal value calculation using the exit multiple method requires assuming that a company will sell mainly on the basis of some measurable financial statistic. This statistic could be the annual sales, gains, taxes, earnings before interest, EBITDA, etc. However, irrespective of the statistic being used, it is important to use values for it prior to any deductions.
Once the statistic to be used has been decided on, one must determine what multiple of the statistic the company is likely to sell for. This is determined based on data from other companies that have been sold.
Terminal value = multiple * financial statistic
Suppose the total annual sales of a company are Rs.20,00,00,000 and other companies have sold for an average amount equivalent to 10 times their annual sales. Then, the terminal value formula based on the above discussion will be as follows:
Terminal value = 10 * Rs.20,00,00,000 = Rs.200,00,00,000.
As seen above, the terminal value formula varies based on the terminal value method being used. Business owners or investors can use either terminal value calculation formula.
Terminal value = [FCF * (1 + S)] / (WACC – S),
where FCF is the free cash flow, S is the stable growth rate, and WACC is the weighted average cost of capital.
Terminal value = multiple * financial statistic
Suppose a group of companies wishes to estimate the value of one of its verticals. It must first decide on the method it wishes to use for the terminal value calculation. Let us assume that the group chooses the stable growth or perpetuity growth method. The declared growth rate of the vertical is 2.5% per annum in perpetuity, and the free cash flow is Rs.25,00,000 at the end of the fifth year (i.e., the end of the forecast period). The weighted average cost of capital is 11%.
Substituting the data above in the terminal value formula, we get
Terminal value = [Rs.25,00,000 * (1 + 2.5%)]/ (11 – 2.5) = Rs.3,01,47,058
This means the future value of the vertical is Rs.3,01,47,058 in terms of the value of money today. It is important to remember that the growth rate is always less than the projected growth rate of the economy that governs the business.
The formula for the present value of a terminal value is:
Present value = Terminal value / (1 + k)n
Present value = Terminal value / WACC
Where k is the cost of capital or investment, WACC is the weighted average cost of capital, and n is the number of years.
The concept of ‘terminal value’ is an important financial tool that can make it possible to make informed business decisions and predict the future of a company. It enables a determination of how much a business is worth today and what its value will be in the future. However, it is only an indicative value, and business owners and investors must evaluate it regularly to maintain accuracy.
Ans: The terminal value is an estimation of the value of a project, company, or asset beyond the initial forecast period.
Ans: The terminal value is calculated to determine the future value of a company or security, and to find out how certain decisions may impact its value.
Ans: As the time horizon for valuation increases, it may become difficult to forecast the future of a company accurately. Analysts and investors thus use financial models, such as the discounted cash flow model, to make predictions. Such models rely on several baseline assumptions, one of which is the terminal value.
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