What is Terminal Value Formula?

3 Most Common Terminal Value Formulas

In DCF Valuation, there are three ways to find terminal value. they are as follows:-

  • Perpetuity Growth MethodExit Multiple Growth MethodNo Growth Perpetuity model

#1 – Perpetuity Growth Method

The Perpetual Growth Method is also known as the Gordon Growth Perpetual ModelGordon Growth Perpetual ModelGordon Growth Model is a Dividend Discount Model variant used for stock price calculation as per the Net Present Value (NPV) of its future dividends. read more. It is the most preferred method. In this method, the assumption is made that the company’s growth will continue, and the return on capital will be more than the cost of capital.

Terminal Value = FCFF6 / (1 + WACC)6 + FCFF7 / (1 + WACC)7 + …..+ Infinity

If we simplify the formula it will be,

Terminal Value = FCFF6 / (WACC – Growth Rate)

FCFF6 can be written as, FCFF6 = FCFF5 * (1 + Growth Rate)

Now, use Formula in the above equation given,

Terminal Value = FCFF5 * (1 + Growth Rate) / (WACC – Growth Rate)

This method is used for mature companies in the market and has stable growth companies Eg. FMCG companiesFMCG CompaniesFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc.read more, Automobile companies.

#2 – Exit Multiple Method

Exit Multiple Method is used with assumptions that market multiple bases to value a business. The terminal multiple can be the enterprise value/ EBITDA Value/ EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more or enterprise value/EBIT, the usual multiples used in financial valuation. The projected statistic is the relevant statistic projected in the previous year.

Terminal Value = Last Twelve months Terminal Multiple * Projected Statistic

#3 – No Growth Perpetuity Model

No growth perpetuity formula is used in an industry where a lot of competition exists, and the opportunity to earn excess return tends to move to zero. In this formula, the growth rate is equal to zero; this means that the return on investment will be equal to the cost of capital.

Terminal Value = FCFF6 / WACC

Eg. It is useful to calculate the GDP of the country.

Examples

Example #1

If the metal sector is trading at ten times the EV/EBITDA multiple, then the company’s terminal value is ten * EBITDA.

Suppose,

  • WACC = 10%Growth Rate = 4%Debit = $100Cash = $60Number of Shares = 200

Find the per share fair value of the stock using the two proposed terminal value calculation method.

Application of Terminal Value Formulas

#1 – Terminal Value – Using the Perpetuity Growth Method

Calculate the NPV of the Free Cash Flow to the Firm for the explicit forecast period (2014-2018)

#2 – Terminal Value – Using Exit Multiple Method

  • Step #1 – For the explicit forecast period (2018-2020), calculate the Free Cash FlowFree Cash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more NPV for the firm. Please refer to the above method, where this step has already been completed.Step #2 – Use the multiple exit methods for terminal value calculation of the stock (end of 2018). Let us assume that the average companies in this industry trade at seven times EV / EBITDA multiples. We can use the same multiple to find this stock’s terminal value.

  • Step #3 – Calculate the Present Value of Explicit FCFF

  • Step #4 – Now, Calculate the Enterprise Value and the Share Price

The terminal value contribution to enterprise value is 80%.

  • Calculate the NPV of the Free Cash Flow to the Firm for the explicit forecast period (2014-2018) The formula for the Present Value of Explicit FCFF is NPV() function in excel.$127 is the net present value for the period 2018 to 2020. Terminal Value calculation (at the end of 2018) using the Perpetuity Growth method Using the Perpetuity Growth method, Terminal Value will be: 1,040 Present Value of Explicit FCFF Now, Calculate the Enterprise Value and the Share Price Please note that the Terminal value contribution to enterprise value is 86% in this example. Generally, the contribution is between 80 – and 90%.

The formula for the Present Value of Explicit FCFF is NPV() function in excel.$127 is the net present value for the period 2018 to 2020.

Using the Perpetuity Growth method, Terminal Value will be: 1,040

Please note that the Terminal value contribution to enterprise value is 86% in this example. Generally, the contribution is between 80 – and 90%.

Relevance and Uses

  • Use in a financial tool like the Gordon growth method.To calculate discounted cash flow examples of the same we have seen above.To calculate residual earnings.

Terminal Value is an important concept in estimating Discounted Cash Flow as it accounts for more than 60% – 80% of the total company’s worth. Special attention should be given to assuming the growth rates, discount rate, and multiples like PEMultiples Like PEThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more, Price to bookPrice To BookPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share read more, PEG ratioPEG RatioThe PEG ratio compares the P/E ratio of a company to its expected rate of growth. A PEG ratio of 1.0 or lower, on average, indicates that a stock is undervalued. A PEG ratio greater than 1.0 indicates that a stock is overvalued.read more, EV/EBITDA, EV/EBIT, etc.

There are some limitations of terminal value in discounted cash flowDiscounted Cash FlowDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future performance.read more; if we use exit multiple methods, we are mixing the DCF approach with a relative valuation approach as the exit multiple arrives from the comparable firm. Terminal value contributes more than 75% of the total value; this becomes risky if the value varies significantly, with even a 1% change in growth rate or WACC. Please note growth cannot be greater than the discounted rate. In that case, one cannot apply the Perpetuity growth method.

Terminal Value Formula Video

This article has been a Guide to Terminal Value Formula. Here we discuss how to calculate the terminal value using the method of perpetuity growth and Exit multiple growths, along with practical examples & a downloadable excel template. You may learn more about Valuations from the following articles –

  • Free Cash Flow from EBITDAValue Formula ExcelNet Present Value FormulaValuation Methods