What is the Terminal Value?

Terminal value (TV) is the primary reason for which a Discounted Cash Flow (DCF) is constructed. It represents the value of the company at the conclusion of the modeled period, hence ‘terminal’ (from the Latin terminus for end; boundary line). As noted in our post on Cost of Capital, terminal value is driven by revenue and invested capital. A DCF model organizes these input to reach that terminus value.

How does Terminal Value differ from Enterprise Value?

Terminal value is future-oriented and based on future free cash flows (FCF), whereas Enterprise Value represents the company’s current value as based on the equity value of the company plus debt, less cash.. An explanation how Terminal Value is calculated may be useful in clarifying this difference further.

How is Terminal Value Calculated?

A financial analyst is able to calculate terminal value using a variety of techniques. The most common of these techniques are (1) Perpetuity Method and (2) Exit Multiple Method.

(1) For the Perpetuity Method, a FCF model based on future revenue and expense expectations is created. Investors assume a constant growth rate, the long-term growth rate. This is multiplied by the last year of the cash flow forecast, typically 5-10 years in the future. This is then divided by the difference between WACC and the long-term growth rate.

(2) For the Exit Multiple Method, the terminal value represents the NRV (net realizable value) of the company’s assets at a given time. Enterprise Value (EV) is often used for this purpose. Generally, EBIT or EBITDA for the current year is multiplied by an industry multiple average. Different industries will have different multiples. Using EV/EBITDA, for example, we can see the average multiple for the farming/agriculture industry is 13.82 and the advertising multiple is 8.35.

Note that the Exit Multiple Method is useful and convenient for public companies, but it may be difficult to find appropriate comparables for a private company. Financial disclosure of private deals are note required by law, and the variety in scope and size of private companies can cause consternation to the financial analyst attempting to find comparables. Further, realize the exit multiple carries an inflated premium. A premium of ~20% is often paid in excess of an acquired companies’ EV, but this is not removed from the multiple. Thus, the value of a company is somewhat dependent on its intended future. Will it be sold to a private equity company through a bidding process? Consider the private equity market has increased 540% in size since 1995. Alternatively, if the company intends to remain privately held without any expected future sale, the enterprise value should not carry any premium. Arguably, EV inherently values a company optimistically given its inclusion of debt in its valuation.

Which of the Perpetuity Method and Exit Multiple Method is Preferred?

Both the Perpetuity Method and the Exit Multiple Method are useful, and each should be considered in arriving at a company’s Terminal Value. The Perpetuity Method is generally less optimistic of the company’s value while the Exit Multiple Method may be most appropriate when comparing public corporations. Valuation reports will often provide the Terminal Value from each of these methods, and give a weight to each.