What is the terminal value (TV)?

Terminal value (TV) is the value of an asset, asset, or project beyond the expected period when it is possible to estimate future cash flows. Terminal value assumes that a business will grow at a predetermined growth rate forever after the forecast period. The terminal value often comprises a significant percentage of the total face value.

Discounted cash flow
Understanding Terminal Value

Predictions become more obscure as the time horizon lengthens. This is also true in finance, especially when it comes to estimating a company’s future cash flows. At the same time, companies must be valued. To solve this problem, analysts use financial models, such as discounted cash flows (DCF), along with certain assumptions to derive the total value of a business or project. Discounted cash flow (DCF) is a popular method for studies, business acquisitions and stock market valuation. This method is based on the theory that the value of an asset is equal to all future cash flows derived from that asset. These cash flows must be discounted to their present value at a discount rate representative of the cost of capital, such as the interest rate. DCF has two main components: forecast period and terminal value. The forecast period is usually about five years. Anything longer than that and the accuracy of the projections suffer. This is where the terminal value calculation becomes important. There are two methods commonly used to calculate the terminal value: perpetual growth (Gordon Growth Model) and multiple productions. The former assumes that a business will continue to generate cash flow at a constant rate forever, while the latter assumes that a business will grow by being sold for a multiple of a market metric. Investment professionals prefer the multiple exit approach while academics prefer the perpetual growth model.

Perpetuity method

Discounting is necessary because the time value of money creates a gap between the present and future values ​​of a given amount of money. In business valuation, free cash flow or dividends may be expected for some time, but lingering concerns become more difficult to estimate as projections extend further into the future. In addition, it is difficult to determine the precise moment when a company could fail.

To overcome these limitations, investors can assume that cash flow will increase at a steady rate forever, starting at some point in the future. This represents the terminal value.

The terminal value is calculated by dividing the last expected cash flow by the difference between the discount rate and the terminal growth rate. The terminal value calculation estimates the value of the business after the forecast period.

The terminal growth rate is the constant rate at which a company is expected to grow indefinitely. This growth rate begins at the end of the last expected cash flow period in a discounted cash flow model and becomes perpetual. A terminal growth rate is generally in line with the long-term rate of inflation, but not higher than the historical growth rate of gross domestic product (GDP).

How is the terminal value estimated?

There are several terminal value formulas. Like discounted cash flow (DCF) analysis, most terminal value formulas project future cash flows to return the present value of a future asset. The liquidation value model (or exit method) requires calculating the earning capacity of the asset at an appropriate discount rate and then adjusting the estimated value of the outstanding debt.

The stable growth model (perpetuity) does not assume that the company will be liquidated after the terminal year. Instead, it assumes that cash flows are reinvested and the business can grow at a constant rate to infinity. The multiples approach uses a company’s approximate revenue in the last year of a discounted cash flow model, then uses a multiple of that figure to arrive at the terminal value with no further discount applied.

What does a negative terminal value mean?

A negative terminal value is estimated if the future cost of capital exceeds the assumed growth rate. In practice, however, the assessments of negative terminals can not exist for very long.

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