Most fundamental investors are familiar with the discounted cash flow model where you project the value of a company's cash flows over a period of time (three-to-five years is standard) and discount based on the time value of money.
The terminal value does something similar, except that it focuses on assumed cash flows for all of the years past the limit of the discounted cash flow model. Typically, an asset's terminal value is added to future cash flow projections and discounted to the present day. Discounting is performed because the terminal value is used to link the money value between two different points in time.
Though there are several terminal value formulas, most project future cash flows – similar to discounted cash flow analysis – to return the present value of a future asset. The exception to this is the multiple approach.
Methods of Discounting for Terminal Value
Suppose an investor used a discounted cash flow formula to find the present value of an asset (or firm) five years into the future. The same investor could use the terminal value to estimate the present value based on all cash flows after the fifth year into the discounted cash flow model.
All future earnings need to be discounted. Since the terminal cash flow has an undefined horizon, calculating exactly how to project a discounted cash flow can be a challenging proposition.
There are three primary methods for estimating terminal value:
1. Liquidation Value Model
The first is known as the liquidation value model. This method requires figuring the asset's earning power with an appropriate discount rate, then adjusting for the estimated value of outstanding debt.
2. Multiple Approach
The multiple approach uses the approximate sales revenues of a firm during the last year of a discounted cash flow model, then uses a multiple of that figure to arrive at the terminal value. For example, a firm with a projected $200 million in sales and a multiple of 3 would have a value of $600 million in the terminal year. There is no discounting in this version.
3. Stable Growth Model
The last method is the stable growth model. Unlike the liquidation values model, stable growth does not assume that the firm will be liquidated after the terminal year. Instead, it assumes that cash flows are reinvested and that the firm can grow at a constant rate in perpetuity.
The discount rate for this model is different depending on whether it's applied to an equity or a firm. The cash flow for an equity is treated like dividends in the dividend discount model. For a firm, the discount rate is more similar to discounted cash flows.
Why Discount Terminal Value?
Most companies do not assume that they will stop operations after a few years. They expect the business will continue forever (or at least a very long time). The terminal value is an attempt to anticipate a firm's future value and apply it to present prices.
This can only be done by discounting future value. The value of money does not stay constant over time, so it doesn't do today's investor any good to only understand the nominal value of a company many years into the future.