Terminal value (finance)
Encyclopedia
In finance
, the terminal value (continuing value or horizon value) 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. 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.
minus the assumed perpetuity growth rate: T0 = FCFN+1/(k – g). T0 is the value of future 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 being the discount rate and g being the growth rate. This equation is a perpetuity, which uses a geometric series to determine the value of a series of growing future cash flows.
To determine the present value of the terminal value, one must discount the Terminal 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. 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.
. 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.
The Perpetuity Growth Model has several inherent characteristics that make it intellectually challenging. Because both the discount rate and growth rate are assumptions, inaccuracies in one or both inputs can provide an improper value. The difference between the two values in the denominator determines the terminal value, and even with appropriate values for both, the denominator may result in a multiplying effect that does not estimate an accurate terminal value. Also, the perpetuity growth rate assumes that free cash flow will continue to grow at a constant rate into perpetuity. Consider that a perpetuity growth rate exceeding the annualized growth of the S&P 500
and/or the U.S. GDP implies that the company's cash flow will outpace and eventually absorb these rather large values. Perhaps the greatest disadvantage to the Perpetuity Growth Model is that it lacks the market-driven analytics employed in the Exit Multiple Approach. Such analytics result in a terminal value based on operating statistics present in a proven market for similar transactions. This provides a certain level of confidence that the valuation accurately depicts how the market would value the company in reality.
On the other hand the Exit Multiple approach must be used carefully, because multiples change over time. Simply applying the current market multiple ignores the possibility that current multiples may be high or low by historical standards. In addition, it is important to note that at a given discount rate, any exit multiple implies a terminal growth rate and conversely any terminal growth rate implies an exit multiple. When using the Exit Multiple approach it is often helpful to calculate the implied terminal growth rate, because a multiple that may appear reasonable at first glance can actually imply a terminal growth rate that is unrealistic.
In practice, academics tend to use the Perpetuity Growth Model, while investment bankers favor the Exit Multiple approach. Ultimately, these methods are two different ways of saying the same thing. For both terminal value approaches, it is essential to use a range of appropriate discount rates, exit multiples and perpetuity growth rates in order to establish a functional valuation range.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, the terminal value (continuing value or horizon value) of a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
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
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
analysis, and allows for the limitation of cash flow projections to a several-year period. 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
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
analysis. For whole-company valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
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 into perpetuity in the future, growing at an assumed constant rate. Here, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. This value is divided by the discount rateDiscount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
minus the assumed perpetuity growth rate: T0 = FCFN+1/(k – g). T0 is the value of future 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 being the discount rate and g being the growth rate. This equation is a perpetuity, which uses a geometric series to determine the value of a series of growing future cash flows.
To determine the present value of the terminal value, one must discount the Terminal 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. 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
Enterprise value
Enterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
.
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/EBITDAEV/EBITDA
EV/EBITDA is a valuation multiple used in finance and investment to measure the value of a company. This important multiple is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.An advantage of this multiple is that it is capital...
. 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
Control premium
Control premium is an amount that a buyer is usually willing to pay over the current market price of a publicly traded company. Contrary to a widely held view, this premium is not justified by the expected synergies, such as the expected increase in cash flow resulting from cost savings and revenue...
. 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.The Perpetuity Growth Model has several inherent characteristics that make it intellectually challenging. Because both the discount rate and growth rate are assumptions, inaccuracies in one or both inputs can provide an improper value. The difference between the two values in the denominator determines the terminal value, and even with appropriate values for both, the denominator may result in a multiplying effect that does not estimate an accurate terminal value. Also, the perpetuity growth rate assumes that free cash flow will continue to grow at a constant rate into perpetuity. Consider that a perpetuity growth rate exceeding the annualized growth of the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
and/or the U.S. GDP implies that the company's cash flow will outpace and eventually absorb these rather large values. Perhaps the greatest disadvantage to the Perpetuity Growth Model is that it lacks the market-driven analytics employed in the Exit Multiple Approach. Such analytics result in a terminal value based on operating statistics present in a proven market for similar transactions. This provides a certain level of confidence that the valuation accurately depicts how the market would value the company in reality.
On the other hand the Exit Multiple approach must be used carefully, because multiples change over time. Simply applying the current market multiple ignores the possibility that current multiples may be high or low by historical standards. In addition, it is important to note that at a given discount rate, any exit multiple implies a terminal growth rate and conversely any terminal growth rate implies an exit multiple. When using the Exit Multiple approach it is often helpful to calculate the implied terminal growth rate, because a multiple that may appear reasonable at first glance can actually imply a terminal growth rate that is unrealistic.
In practice, academics tend to use the Perpetuity Growth Model, while investment bankers favor the Exit Multiple approach. Ultimately, these methods are two different ways of saying the same thing. For both terminal value approaches, it is essential to use a range of appropriate discount rates, exit multiples and perpetuity growth rates in order to establish a functional valuation range.
See also
- Asset retirement obligationAsset retirement obligationAsset Retirement Obligations provide for future disposal of assets as required by SFAS 143 .Firms must recognize the ARO liability in the period it was acquired, generally acquisition. The liability equals the market value, and if that is not available the present value of cash flows that will be...
- Business valuationBusiness valuationBusiness valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...
- Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Geometric series
- Net present valueNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
- PerpetuityPerpetuityA perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence...
- Terminal value (accounting)
External Links and references
- Closure in Valuation: Estimating Terminal Value, Prof. Aswath DamodaranAswath DamodaranAswath Damodaran is a Professor of Finance at the Stern School of Business at New York University , where he teaches corporate finance and equity valuation...
, Stern School of Business