What is Terminal Value (TV)?
Terminal value (TV) represents all future cash flows in an asset valuation model. This allows models to reflect returns that will occur so far in the future that they are nearly impossible to forecast. The Gordon Growth Model, discounted cash flow, and residual earnings use terminal values that can be calculated with perpetuity growth, while an alternative exit valuation approach employs relative valuation methods.
Breaking Down Terminal Value (TV)
Discounted cash flow (DCF) is a popular method used in feasibility studies, corporate acquisitions, and stock market valuation. This method is based on the theory that an asset's value is equal to all future cash flows derived from that asset. These cash flows must be discounted to the present value at a discount rate representing the cost of capital, such as the interest rate.
Discounting is necessary because the time value of money creates a discrepancy between the current and future values of a given sum of money. In business valuation, free cash flow or dividends can be forecast for a discrete period of time, but the performance of ongoing concerns becomes more challenging to estimate as the projections stretch further into the future. Moreover, it is difficult to determine the precise time when a company may cease operations.
To overcome these limitations, investors can assume that cash flows will grow at a stable rate forever, starting at some point in the future. This represents the terminal value, and it is calculated by dividing the last cash flow forecast by the difference of the discount rate and the stable growth rate.
Consider the valuation of Facebook Inc. as of July 2016. The summed present value of analyst consensus future cash flow falls in the $18 to $20 per share range, meaning the terminal value is implicitly $100, based on DCF and $118 share prices.
Exit Multiple Method
If investors assume a finite window of operations, there is no need to use the perpetuity growth model. Instead, the terminal value must reflect the net realizable value of a company's assets at that time. This often implies the equity will be acquired by a larger firm, and the value of acquisitions are often calculated with exit multiples.
Exit multiples estimate a fair price by multiplying financial statistics, such as sales, profits, or earnings before interest, taxes, depreciation, and amortization (EBITDA) by a factor that is common for similar firms that were recently acquired. Investment banks often employ this valuation method, but some detractors hesitate to use intrinsic and relative valuation techniques simultaneously.