Terminal Value

In most business valuations, the business is expected to run in perpetuity.  The exception being businesses with a finite life like mines or toll roads.

Valuations will forecast earnings for say 5 or 10 years and then the value of the cash flows from the end of the forecast period to perpetuity will be determined in the terminal value.

The terminal value often presents the largest component of a discounted cashflow (DCF) valuation and therefore care must be exercised in its calculations and the relevant assumptions used.

Terminal value is often assumed to represent the price that the business could be sold for at the end of the forecast period (ie. in 10 years’ time, the business could be sold for $xxx).  The perception often presents problems for non-business values as the uncertainty attached to the business in 10 years’ time.

The terminal value represents the cash flows that the business will be expected to achieve in the future.  This presents a number of problems particularly as the life cycle of businesses and products is shortening with increased technological developments, competition and new markets developing in Asia.

In general, the business is always assumed to continue growing and cashflow forecasts are rarely shown to decrease.  When a company is seen to have shrinking cash flows, the market price will often decrease dramatically as the terminal value in the valuation models is decreased.

In determining the terminal value, the following issues should be considered:

• Time Horizon:  How far out should cash flows be forecast
• Cyclicality of earnings:  At what stage is the business and its products or services in its development
• Competitive Advantage Period:  How long could the business sustain its current return on investment especially if it exceeds WACC (Weighted Average Cost of Capital).  If it exceeds WACC, new competitors will be drawn into the market.
• Growth Rates:  What growth rate should apply during the forecast period and what growth rate should apply into perpetuity.  Once an asset reaches maturity, growth rates in line with nominal GDP are a reasonable figure to use.
• Capital Expenditure:  what capital expenditure is required to sustain the business in the long term.

How to Calculate Terminal Value

Perpetuity Method

The perpetuity method is generally used to calculate terminal value.  It considers future cash flows as an annuity and divides this annuity by the discount rate in order to determine the residual value.  The residual value is then discounted to today’s value (present value) using the discount rate to arrive at the terminal value.

The formula is basically:

Where:

TVt           =             terminal value at Year 1 (end of explicit forecast period)

CFt+1    =             cash flow in Year 1 after the end of the forecast period.

r              =             discount rate

The perpetuity model does not assume growth beyond the forecast period.  In order to assume long term growth (say, CPI or nominal GPD) it is necessary to adapt the formula as follows:

Where g = growth rate (as constant).

Alternate Methods to Calculating Terminal Value

There are alternative methodologies to assessing terminal values including:

• EBITA Multiples
• EBIT Multiples
• Price to Earnings Multiples
• Using liquidation or book values of assets.

When using multiples, it is necessary to ensure that the multiples are consistent with the discount rate.  By their nature, earnings multiples and price to earnings multiples include not only long term growth but also short term growth which has already been taken into account in the cash flow forecasts.  A PE ratio includes both a discounted rate and future earnings growth in its calculation.

Conclusion

Great care must be exercised in the calculation of terminal value and all DCF valuations should be examined closely as to the assumption used in the determination of terminal value as it comprises a massive component of the value of the entity.