In the income method to valuation, the present value of terminal value is a significant aspect in constructing a discounted cash flow (DCF) valuation report. It usually accounts for a significant portion of a company’s entire worth.
For a typical firm, the terminal value indicates predicted cash flow beyond the projection period, which is generally three to five years; this is regarded an acceptable amount of time for making specific assumptions about future performance. However, assumptions become increasingly hazy and speculative when going beyond that time frame, which is when the terminal value comes into play.
The multiple approaches for calculating the DCF terminal value, as well as the limits and hazards to be aware of when utilizing the terminal value in valuations, will be discussed in this article.
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Methods For Calculating The Present Value Of Terminal Value
There are two main approaches for calculating terminal value: the perpetual growth model and the exit multiple model. Each approach has two major components: the forecast period and the terminal value.
Perpetual Growth DCF Formula For Calculating Terminal Value
The perpetual growth terminal value formula is:
TV = (FCFn x (1 + g)) / (WACC – g)
TV = terminal value
FCF = free cash flow
n = normalized rate
g = perpetual growth rate of FCF
WACC = weighted average cost of capital
Academics prefer the everlasting growth formula because it is based on mathematical and financial theory. This method assumes a constant normalized rate of free cash flow (FCF).
That works fine in theoretical, academic applications, but most firms do not function indefinitely in the actual world. As a result, valuation specialists frequently, although not always, utilize the following procedure to determine the terminal growth value.
Exit Multiple DCF Formula For Calculating Terminal Value
The exit multiple terminal value formula is:
TV = Financial metric (EBITDA or other) ✕ trading multiple
Limitations And Risks Of The Terminal Value Method
The terminal value method’s most significant drawback is its vulnerability to tiny changes in essential assumptions. When employing the perpetual growth technique to calculate the terminal value, the terminal value formula WACC and growth rate assumptions will both have a significant impact on the value calculated and may account for the majority of the valuation.
This happens because the income method is divided into two parts: calculating the present value of cash flows over the projected period and calculating the terminal value separately. Because terminal value is based on long-term assumptions, making the wrong ones might have a substantial impact on the value. As a safeguard, make sure that the majority of the valuation isn’t based on the terminal value, which is predicted to be distant in the future and unclear.
These are the same assumptions that can impact a valuation using the income approach itself; as a result both the income approach and terminal value calculations are most reliable for businesses with stable and predictable cash flows.
Another risk associated with the perpetual growth strategy is growth assumptions. Due to investor euphoria or the interests of business sellers, these are frequently exaggerated. Because the perpetual growth model is built on a terminal value that is supposed to last endlessly, no firm can develop faster than the general economy’s growth rate indefinitely. Otherwise, the business would take over and become the economy, which would be impossible. The projection period can include above-average growth assumptions when using this technique, but the long-term growth assumption must be trended down to the general economy’s long-term growth rate.
When utilizing the exit multiples approach to calculate the terminal value, the following concerns arise: There is no direct relationship between EBITDA or EBIT and the value of a company; it is only a guideline. Another problem is that EBITDA is a non-GAAP valuation metric, which means it isn’t well-defined and can be manipulated in valuation and analysis. The peer universe is the third significant issue: Where did the exit multiple come from? It’s at best a guess based on comparable company sales, which is likely to be a small sample size and not directly comparable to the subject firm.
One further risk related to the terminal value approach in general is that there are many businesses that should not be valued based on this methodology, because their operating life is not likely to be indefinite. In these cases, the terminal value approach will materially overstate value. For example, when valuing a hedge fund, the assumption of indefinite operating life is inappropriate, since the average life of hedge funds tends to be just a few years, with subsequent closure due to underperformance, unexpected investor withdrawals, market conditions, and other reasons.
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