Terminal Value 101: A Critical Part Of Company Valuation

Terminal value plays a significant role in discounted cash flow (DCF) analyses and other valuation models.

Investors often project a company’s free cash flows up to a certain point—usually five to ten years into the future. In these forecast periods, investors can adjust their assumptions to derive different figures for the company’s intrinsic value—what it is worth. 

But a company doesn’t disappear after the fifth or tenth year. Unless the company files for bankruptcy or is acquired, it generates cash flows indefinitely.

So, how do investors account for a company’s future cash flows beyond the forecast period in their financial models?

It’s all wrapped up in terminal value.

What Is Terminal Value?

In financial models, terminal value (TV) estimates the value of a company’s future cash flows beyond an investor’s forecast period. If an investor performs a 5-year DCF on Example Industries, the terminal value will account for the company’s cash flows in year 6, year 7, year 8 and so on.

Terminal value is often a sizeable figure because it attempts to capture all the company’s growth and cash flow generation beyond the forecast period. Like all figures in the forecast period, terminal value is an estimate.

Note: 

From here on out, we’ll explain terminal value through the scope of the discounted cash flow (DCF) model. Terminal value also applies to most other valuation models.

Why Is It Important?

Terminal value is a cornerstone of financial valuation and influences how investors view a company’s long-term potential and associated risks. Its importance can be summarised in the following points.

It’s A Major Contributor To Company Valuation

Because it attempts to capture the value of cash flows beyond an investor’s forecast period, terminal value can sometimes account for over 50% of a company’s total valuation. This makes it an essential component in estimating intrinsic value.

It may seem there is an over-reliance on terminal value, but this need not always be the case. Remember, a company doesn’t stop trading after a forecast period of five or ten years – they trade indefinitely into the future. 

So, for example, if a company trades for 50 years beyond a 10-year forecast period, its terminal value should account for a large proportion of its valuation.

It Influences Investor Decision-Making

Reasonable estimates of terminal value help investors identify undervalued companies and avoid potentially overvalued ones. Based on a company’s terminal value and its effects on intrinsic value, investors may purchase shares in a new company, buy more shares in a company they already own, maintain their current position or sell.

Similarly, understanding a company’s terminal value (and the assumptions used in its computation) allows investors to assess the long-term risks and rewards associated with a company. If a company’s terminal value is overly sensitive to a change in a forecast assumption, its long-term risks may outweigh its long-term rewards.

It Simplifies Valuation Models

Projecting cash flows indefinitely into the future is complex and impractical – the further into the future, the higher the uncertainty. Hence, investors usually forecast between 5 and 10 years. 

Because companies don’t stop trading at the end of an analyst’s forecast period, there must be a figure to capture all the future cash flows beyond the forecast period – terminal value.

If such a value were not integrated into the valuation process, analysts would have to forecast individual future cash flows, which increases the complexity, uncertainty, length and likelihood of error in a valuation model.

Terminal Value Calculation with Examples

Like most things in finance and investing, there are multiple ways of calculating terminal value. They include the:

• Perpetuity Growth Model
• Exit Multiple Approach

Perpetuity Growth Model

As the name suggests, this method assumes that a company’s free cash flows will grow perpetually (forever) at a constant growth rate. This approach is used most often in financial models.

The Perpetuity Growth Model considers a terminal growth rate for the company’s cash flows beyond the forecast period. This rate is often based on the GDP growth rate of the company’s country of origin. (The terminal value of UK companies will be calculated using historical UK GDP growth data).

The idea is that the company will either outperform, underperform or grow in line with the country’s economy indefinitely. A terminal growth rate higher than the country’s economic growth rate suggests the investor expects the company to grow faster than the country’s economy perpetually.

The following formula calculates terminal value using the Perpetuity Growth Model.

Where:

• FCF_f = final year free cash flow forecast
• g = terminal growth rate
• r = discount rate

Example:

Let’s say an investor’s forecast period is five years, and the final year’s free cash flow is £10,000. Assuming a 3% terminal growth rate and a 9% discount rate, the company’s terminal value would be £171,667—the estimated value of all its cash flows beyond the 5-year forecast period.

Exit Multiple Approach

The Exit Multiple Approach calculates a company’s terminal value using the forecasted financial figure and its corresponding market multiple. If an investor forecasts free cash flows, the corresponding market multiple will be P/FCF (price-to-free cash flow). Similarly, if an investor forecasts earnings, the corresponding multiple will be P/E (price-to-earnings).

The exit multiple used isn’t necessarily the company’s own. Investors often analyse the company’s market multiple along with those of comparable companies (a company’s peers) to estimate the multiple to use. For instance, if a company has a 30x P/FCF and five of its comparable companies have P/FCFs of around 20x, investors may use an average of them all or the 20x multiple of the comparables.

The idea behind the exit multiple approach is to show the investor what the company may be worth if it stopped trading at the end of the forecast period. 

The following formula calculates terminal value using the Exit Multiple Approach.

Where:

• FCF_f = final year free cash flow forecast

Example:

Let’s say an investor’s forecast period is five years. Assuming the final year’s free cash flow is £10,000, and the corresponding exit multiple (P/FCF) is 20x, the company’s terminal value would be £200,000.

Section Summary

The £200,000 terminal value from the Exit Multiple Approach and the £171,667 from the Perpetuity Growth Model would then be discounted to their present values and added to the present values of the cash flows from the forecast period to compute the company’s intrinsic value. 

For an in-depth article on why cash flows are discounted, click here.

Common Pitfalls & Challenges

Subjectivity & Sensitivity

Because of the assumptions involved, a company’s terminal value is highly subjective and sensitive. This is especially the case with the Perpetuity Growth model. A small change in the terminal growth rate or the discount rate can significantly impact the estimated terminal value.

Take, for instance, the example below.

Let’s say two investors are valuing the same company. They forecast the same future cash flows, and their final year free cash flow amounts to £15,000. Investor A decides the company’s terminal growth rate is 3%, and Investor B assumes a terminal growth rate of 3.5%. Both investors use a discount rate of 6%.

A 0.5% difference in terminal growth rates yielded a £106,000 higher terminal value for Investor B. In Investor B’s eyes, the company is much more valuable than Investor A is giving it credit for.

Subjectivity is also present when using the Exit Multiple Approach since investors must assume an exit multiple. However, sensitivity to change is of a lesser degree than that of the Perpetuity Growth Model. With the Exit Multiple Approach, you’re simply multiplying by a constant.

The 10x difference in exit multiple (20x versus 30x) led to a £100,000 increase in terminal value.

Overestimating Growth Rates or Using Abnormally High Exit Multiples

Since company valuations rely entirely on assumptions, using higher-than-normal terminal growth rates and exit multiples is a real challenge.

With the Perpetuity Growth Model, a higher terminal growth rate and a lower discount rate will generate a higher terminal value. It’s the same with the Exit Multiple Approach – the higher the multiple, the higher the terminal value. Because terminal value often makes up the bulk of a company’s value, a higher terminal value will lead to a higher intrinsic value. 

Now for the issue.

Investors sometimes use higher terminal growth rates and exit multiple to justify a company’s stock price. The higher the terminal value, the higher the company’s intrinsic value and the cheaper the current stock price looks. 

This mindset should be avoided at all costs. If the company isn’t cheap enough using achievable growth rates and exit multiples, then it’s not cheap. Don’t fiddle with assumptions to make an expensive company look cheap – it will only come back to haunt you.

Underestimating Discount Rates

This challenge only occurs in the Perpetuity Growth Model. 

The discount rate matters not only because it represents the risk associated with the company (the higher the risk, the higher the discount rate) but also because it appears in the denominator of the equation. Since it is in the denominator, the lower the discount rate, the higher the terminal value and overall value of the company. This may incentivise investors to use a lower discount rate instead of one that adequately reflects the company’s risk.

For example.

Let’s say two investors are assessing the same company, and their forecasted final year free cash flow amounts to £15,000. Investor A decides on a 10% discount rate, which adequately reflects the company’s risk, while Investor B chooses a 7% discount rate, downplaying the company’s risk. Both investors use a terminal growth rate of 3%.

Investor B’s terminal value exceeds Investor A’s by £165,536. This will lead to a higher overall company valuation for Investor B, making its current stock price look cheaper. 

But at what cost? 

It’s always best to err on the side of caution when valuing companies because, in a model requiring several assumptions, it is more likely for the assumptions not to happen than for them to happen.

Summary

In conclusion, terminal value estimates a company’s value beyond an investor’s forecast period. While its calculation involves assumptions and inherent subjectivity, terminal value is crucial for understanding a company’s long-term growth potential.

Investors use the Perpetuity Growth Model and Exit Multiple Approach to derive terminal value, ensuring their valuations account for indefinite cash flows. 

By carefully balancing assumptions and exercising caution, terminal value enables more accurate and reliable assessments of a company’s intrinsic value, guiding informed investment decisions.

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