In finance, the terminal value (also known as “continuing value” or “horizon value” or "TV") of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period; see Forecast period (finance). Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.
Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. The terminal value is calculated in accordance with a stream of projected future free cash flows in discounted cash flow analysis. For whole-company valuation purposes, there are two methodologies used to calculate the Terminal Value.
Perpetuity Growth Model
The Perpetuity Growth Model accounts for the value of free cash flows that continue growing at an assumed constant rate in perpetuity; essentially, a geometric series which returns the value of a series of growing future cash flows (see Dividend discount model #Derivation of equation). Here, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. This value is then divided by the discount rate minus the assumed perpetuity growth rate (see Sustainable growth rate #From a financial perspective ):
D0 = Cash flows at a future point in time which is immediately prior to N+1, or at the end of period N, which is the final year in the projection period. k = Discount Rate. g = Growth Rate.
T0 is the value of future cash flows; here dividends. When the valuation is based on free cash flow to firm then the formula becomes , where the discount rate is correspondingly the weighted average cost of capital.
To determine the present value of the terminal value, one must discount its value at T0 by a factor equal to the number of years included in the initial projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1 + k)5 (or WACC). The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied enterprise value.
If the growth rate in perpetuity is not constant, a multiple-stage terminal value is calculated. The terminal growth rate can be negative, if the company in question is assumed to disappear in the future.
Exit Multiple Approach
The Exit or Terminal Multiple Approach assumes a business will be sold at the end of the projection period. Valuation analytics are determined for various operating statistics using comparable acquisitions. A frequently used terminal multiple is Enterprise Value/EBITDA or EV/EBITDA. The analysis of comparable acquisitions will indicate an appropriate range of multiples to use. The multiple is then applied to the projected EBITDA in Year N, which is the final year in the projection period. This provides a future value at the end of Year N. The terminal value is then discounted using a factor equal to the number of years in the projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1+k)5. The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied Enterprise Value. Note that if publicly traded comparable company multiples must be used, the resulting implied enterprise value will not reflect a control premium. Depending on the purposes of the valuation, this may not provide an appropriate reference range.
Comparison of methodologies
There are several important differences between the two approaches.