Terminal value (TV) is a crucial aspect of valuing an investment, a company, or a project. It represents the present value of all future cash flows beyond a specific point in time, often used in conjunction with forecasts to determine the overall worth of an asset. In this article, we will be exploring various methods of calculating terminal value and providing you with a step-by-step guide to ensure you get accurate results.

Methods of Calculating Terminal Value

There are two primary methods for calculating terminal value: the Gordon Growth Model and the Exit Multiple Method.

1. The Gordon Growth Model (Perpetuity Growth Model)

The Gordon Growth Model is a widely-used technique that assumes cash flows will grow at a consistent rate indefinitely. By estimating the rate at which future cash flows will grow, investors can better determine an investment’s terminal value. Follow these steps to calculate terminal value using the Gordon Growth Model:

Step 1: Determine the Free Cash Flow (FCF) that will be generated in the last projected year.

Step 2: Estimate a long-term growth rate for the FCF, usually lower than or equal to the economy’s average growth rate.

Step 3: Determine your discount rate, which is your required rate of return on investment.

Step 4: Use the following formula:

Terminal Value = [FCF * (1 + growth rate)] / (discount rate – growth rate)

2. The Exit Multiple Method

The Exit Multiple Method calculates terminal value by using multiples of key financial measures such as earnings before interest, taxes, depreciation, and amortization (EBITDA). This method is especially useful when analyzing companies within a particular industry where valuation multiples are common. Follow these steps to calculate terminal value using the Exit Multiple Method:

Step 1: Determine your company’s EBITDA for the last projected year.

Step 2: Select a relevant multiple to apply to the EBITDA, which is often based on comparable companies’ trading multiples or industry averages.

Step 3: Multiply the EBITDA by the selected multiple to calculate terminal value.

Terminal Value = EBITDA * Multiple

Discounting Terminal Value

Regardless of which method you choose, you must discount the terminal value back to its present value to include it in your overall valuation. To do this, follow these steps:

Step 1: Calculate your terminal value using one of the methods described above.

Step 2: Determine your weighted average cost of capital (WACC) or an appropriate discount rate.

Step 3: Estimate the number of years from now until the last projected year when the terminal value was calculated.

Step 4: Apply the following formula:

Present Value of Terminal Value = Terminal Value / (1 + discount rate)^number of years

Conclusion

Calculating terminal value is an essential step in understanding a company’s or project’s overall worth. By employing either the Gordon Growth Model or Exit Multiple Method, along with discounting future cash flows back to their present values, investors can more accurately assess their investments and make informed decisions.