Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.

Forecasting gets murkier as the time horizon grows longer. This holds true in finance as well, especially when it comes to estimating a company's cash flows well into the future. At the same time, businesses need to be valued. To "solve" this, analysts use financial models, such as discounted cash flow (DCF), along with certain assumptions to derive the total value of a business or project. Product Design Service

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 equals 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.

DCF has two major components: forecast period and terminal value. Analysts use a forecast period of about three to five years—anything longer than that and the accuracy of the projections suffer. This is where calculating terminal value becomes important. However, this period is often longer for certain industries, like those involved in natural resource extraction.

Two commonly used methods to calculate terminal value are perpetual growth (Gordon Growth Model) and exit multiple. The former assumes that a business will continue to generate cash flows at a constant rate forever, while the latter assumes that a business will be sold for a multiple of some market metric. Investment professionals prefer the exit multiple approach, while academics favor the perpetual growth model.

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 figuring out the asset's earning power with an appropriate discount rate and then adjusting for the estimated value of outstanding debt.

The stable (perpetuity) growth model does not assume the company 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 into perpetuity. The multiples approach uses the approximate sales revenues of a company during the last year of a discounted cash flow model, then uses a multiple of that figure to arrive at the terminal value without further discounting applied.

The Gordon Growth Model is named after Myron Gordon, an economist at the University of Toronto, who worked out the basic formula in the late 1950s.

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, 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 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.

Terminal value is calculated by dividing the last cash flow forecast by the difference between the discount and terminal growth rates. The terminal value calculation estimates the company's value after the forecast period.

Assuming cash flows will grow at a constant rate forever, the formula to calculate a firm's terminal value is:

The terminal growth rate is the constant rate at which a company is expected to grow forever. This growth rate starts at the end of the last forecasted cash flow period in a discounted cash flow model and goes into perpetuity. A terminal growth rate is usually in line with the long-term inflation rate but not higher than the historical gross domestic product (GDP) growth rate.

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 that 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 recently acquired and similar firms. The terminal value formula using the exit multiple method is the most recent metric (i.e., sales, EBITDA, etc.) multiplied by the decided-upon multiple (usually an average of recent exit multiples for other transactions). Investment banks often employ this valuation method, but some detractors hesitate to use intrinsic and relative valuation techniques simultaneously.

Terminal value accounts for a significant portion of the total value of a business in a DCF model, as it represents the value of all future cash flows beyond the projection period. This means that the assumptions made about terminal value can significantly impact the overall valuation of a business.

Terminal value is not the same as net present value (NPV). Terminal value is a financial concept used in discounted cash flow (DCF) analysis and depreciation to account for the value of an asset at the end of its useful life or of a business past some projection period.

Net present value (NPV) measures the profitability of an investment or project. It is calculated by discounting all future cash flows of the investment or project to the present value using a discount rate and then subtracting the initial investment. NPV is used to determine whether an investment or project is expected to generate positive returns or losses. It is a commonly used tool in financial decision-making, as it helps to evaluate the attractiveness of an investment or project by considering the time value of money.

Most companies do not assume they will stop operations after a few years. They expect business to continue forever (or at least for a very long time). Terminal value is an attempt to anticipate a company's future value and apply it to present prices through discounting.

In DCF analysis, neither the perpetuity growth model nor the exit multiple approach is likely to render a perfectly accurate estimate of terminal value. The choice of which method of calculating terminal value to use depends partly on whether an investor wishes to obtain a relatively more optimistic estimate or a relatively more conservative estimate.

Generally speaking, using the perpetuity growth model to estimate terminal value renders a higher value. Investors can benefit from using both terminal value calculations and then using an average of the two values arrived at for a final estimate of NPV.

A negative terminal value would be estimated if the cost of future capital exceeded the assumed growth rate. In practice, however, negative terminal valuations cannot exist for very long. A company's equity value can only realistically fall to zero at a minimum, and any remaining liabilities would be sorted out in a bankruptcy proceeding. Whenever an investor comes across a firm with negative net earnings relative to its cost of capital, it's probably best to rely on other fundamental tools outside of terminal valuation.

Terminal value is the estimated value of an asset at the end of its useful life. It is used for computing depreciation and is also a crucial part of DCF analysis, as it accounts for a significant portion of the total value of a business. Terminal value can be calculated using the perpetual growth method or the exit multiple method. Terminal value is a crucial part of DCF analysis as it accounts for a significant portion of the total value of a business. It is important to carefully consider the assumptions made when calculating terminal value, as they can significantly impact a business's overall valuation.

PwC. "4.4 Valuation Approaches, Techniques, and Methods."

New York University, Leonard N. Stern School of Business. "Estimating Terminal Value (Aswath Damodaran)."

The Review of Economics and Statistics via JSTOR. "Dividends, Earnings, and Stock Prices."

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