Terminal value is the value of a company’s expected free cash flow beyond the period of explicit projected financial model. This tutorial focuses on ways in which Terminal Value is calculated in the context of Company Financial Model. –
- Calculate Terminal Value?
- Why Terminal Value
- Terminal Value Formula
- Terminal Value Calculations – Perpetuity Growth & Exit Multiple Method
- Terminal Value Excel Example
- Alibaba’s Terminal Value (using Perpetuity Growth Method)
- Can Terminal Value ever be Negative?
- Limitations of Terminal value
1) Investment Banking Program 99 Course Bundle, 500+ hours
2) Business and Financial Modeling (University of Pennysylvania)
3) Wharton Business and Financial Modeling Capstone (University of Pennysylvania)
4) Introduction to Finance: Valuation and Investing (University of Michigan)
5) Valuing Projects and Companies (University of Michigan)
Useful Downloads – 1) Free Terminal Value Excel Templates (used in the post) and 2) Alibaba IPO Terminal Value Calculation Model
Calculate Terminal Value
Terminal value calculation is a key requirement of the Discounted Cash Flow.
- It is very difficult to project the company’s financial statements showing how they would develop over a longer period of time.
- The confidence level of financial statement projection diminishes exponentially for years which are way farther from today.
- Also, macro economic conditions affecting the business and the country may change structurally
- Therefore, we simplify and use certain average assumptions to find the value of the firm beyond the forecast period (called as “Terminal Value”) as provided by Financial Modeling.
Following graph shows how to calculate Terminal Value
Why Terminal Value?
In this section, i have briefed the overall approach to performing the Discounted Cash Flows or DCF valuation of any company. Especially, please note Step # 3 where we calculate Terminal Value of the Firm to find the Fair value of Share.
Step # 1: Create the Infrastructure (not discussed in this article)
Prepare a blank excel sheet with Separate Income Statement, Balance Sheet and Cash Flows (last 5 years)
Populate the historical financial statements (IS, BS, CF) and do the necessary adjustment for Non-recurring items (one time expenses or gains).
Perform the Ratio Analysis for Historical years to understand the company
Step #2: Project the Financial Statements and FCFF (not discussed in this article)
- Forecasting of Income Statement (P&L) is most important for analysts. Hence, you must devote lot of time to this. In this, you need to read through the annual report and other documents to get a solid understanding of forecasting
- It is advisable that you also read through other brokerage house research reports to understand how they have modeled sales numbers.
- Forecast the financial statements for the next 5 years (explicit forecast period) – financial model
- When you forecast the company’s financial statements, you must only project the financial statements of the company for the next 4-5 years and generally not beyond that.
- We can theoretically project the financial statements for the next 100-200 years, however, if we do so, we introduce a lot of volatility based on assumptions.
Step #3: Find the fair Share Price of the Firm by discounting the FCFF and Terminal Value
- Calculate FCFF for the next 5 years as derived from the Financial Model
- Apply a suitable WACC (weighted average cost of capital) from the capital structure calculations.
- Calculate the Present value of the Explicit Period FCFF
- Calculate the Terminal Value of the Company (period beyond the Explicit Period)
- Enterprise Value = Present alue (Explicit Period FCFF) + Present Value (Terminal Value)
- Find Equity Value of the Firm after deducting Net Debt
- Divide Equity Value of the Firm by the total number of shares to arrive at “Intrinsic Fair Value” of the company.
- Recommend whether to “BUY” or “SELL”
Also, look at Enterprise value vs Equity Value
Terminal Value Formula
An important assumption here is the “Going Concern” of the company. In other words, the company will not stop its business operations after a few years, however, it will continue to do business forever. The value of the firm (Enterprise Value) is basically the present value of all the future Free Cash Flows to Firm.
We can represent Value of the firm using the formula below –
t = time, WACC is weighted average cost of capital or discount rate, FCFF is the Free Cash Flows to Firm
We can break the above formula into two parts 1) Present Value of Explicit forecast 2) Present Value of Terminal Value
Terminal Value Calculations
There are three approaches for calculating the Terminal Value of the Firm. The first two approaches assume that the company will exist on a going concern basis at the time of estimation of terminal value. The third approach assumes the company is taken over by a larger corporate thereby paying the acquisition price. Let us look at these approaches in detail.
Download the Terminal Value Excel Sheet for the example below –
1) Perpetuity Growth Method or Gordon Growth Perpetuity Model
Please remember that the assumption here is that of “going concern”.
This method is the preferred method to calculate the Terminal Value of the firm. This method assumes that growth of the company will continue (stable growth rate) and the return on capital will be more than cost of capital. We discount the Free cash flow to firm beyond the projected years and find the Terminal Value.
Using cool maths, we can simplify the formula as per below –
Numerator of the above formula can also be written as FCFF (6) = FCFF (5) x (1+ growth rate)
The revised formula is as follows –
A reasonable estimate of the stable growth rate here is the GDP growth rate of the country. Gordon Growth Method can be applied in companies that are mature and the growth rate is relatively stable. Example could be mature companies in automobile sector, consumer goods sector etc.
2) No Growth Perpetuity Model
This method assumes that the growth rate is zero! This assumption implies that the return on new investments is equal to the cost of capital.
Non-growth perpetuity formula
This methodology may be useful in sectors where competition is high and opportunity to earn excess returns tend to move to zero.
3) Exit Multiple Method
This approach uses the underlying assumption that market multiple basis is a fair approach to value a Businesses. A value is typically determined as a multiple of EBIT or EBITDA. For cyclical businesses, instead of the EBITDA or EBIT amount at the end year n, we use an average EBIT or EBITDA over the course of a cycle. For example, if metals and mining sector is trading at 8 times the EV/EBITDA multiple, then the terminal value of the company implied using this method would be 8 x EBITDA of the company.
Terminal Value Calculation Example in Excel
In this example, we calculate the fair value of the stock using the two terminal value calculation approaches discussed above. You can download the Terminal Value Excel template for the example below –
In addition to the above information, you have the following information –
- Debt = $100
- Cash = $50
- Number of shares = 100
Find the per share fair value of the stock using the two proposed terminal value calculation method
Share Price Calculation – using Perpetuity Growth Method for Terminal Value
Step 1 – Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast period (2014-2018)
Step 2 – Calculate the Terminal Value of the Stock (at the end of 2018) using Perpetuity Growth method
Step 3 – Calculate the Present Value of the Terminal Value
Step 4 – Calculate the Enterprise Value and the Share Price
Please note that in this example, Terminal Value contribution towards Enterprise value is 78%! This is no exception. Generally you will note that the Terminal Value contribution is between 60-80% of the total value.
Share Price Calculation – using Exit Multiple Method for Terminal Value
Step 1 – Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast period (2014-2018). Please refer to the above method, where we have already completed this step.
Step 2 – Calculate the Terminal Value of the Stock (at the end of 2018) using Exit Multiple Method. Let us assume that in this industry, the average companies are trading at 7x EV/EBITDA multiple. We can apply this very same multiple to find the terminal value of this stock.
Step 3 – Calculate the Present Value of the Terminal Value
Step 4 – Calculate the Enterprise Value and the Share Price
Please note that in this example, Terminal Value contribution towards Enterprise value is 77%!
With both the methods, we are getting share prices that are very close to each other. Sometimes, you may note large variations in the share prices and in that case, you need to validate your assumptions to investigate such large difference in share prices using the two methodologies.
Alibaba’s Terminal Value (using Perpetuity Growth Method)
You may download Alibaba’s Financial Model from here. Below diagram details the free cash flow to firm of Alibaba and the approach to find the fair valuation of the firm.
Valuation of Alibaba = Present Value of FCFF (2015-2022) + Present Value of FCFF (2023 until infinite “Terminal Value”)
Step 1 – Calculate the NPV of the Free Cash flow to Firm of Alibaba for the explicit period (2015-2022)
Step 2 – Calculate the Terminal value of Alibaba at the end of year 2022 – In this DCF model, we have used the Perpetuity Growth method to calculate the Terminal Value of Alibaba
Step 3. Calculate the Net Present Value of the Terminal Value.
Step 4 – Calculate the Enterprise Value and Fair Share Price of Alibaba
Please note that Terminal Value contributes approximately 72% of the total Enterprise Value in case of Alibaba
Can Terminal Value be Negative?
Theoretically YES, Practically NO!
Theoretically, this can happen when Terminal value is calculated using the perpetuity growth method
In the formula above, if we assume WACC < growth rate, then the Terminal Value derived from the formula will be Negative. This is very difficult to digest as a high growth company is now showing a negative terminal value just because of the formula used. However, this high growth rate assumption is incorrect. We cannot assume that a company is going to grow at a very high rate until infinite. If this is the case, then this company will attract all the capital available in the world. Eventually, the company would become the entire economy and all people working for this company (Awesome! unfortunately this is unlikely!)
When doing valuation, a negative terminal value doesn’t exist practically. However, if the company is in huge losses and is going to bankrupt in the future, the equity value will become zero. Another case could be if company’s product is becoming obsolete like the typewriters or pagers or Blackberry(?). Here also, you may land up in a situation where equity value may literally become closer to zero.
Limitations of Terminal Value
- Please note If we use the exit multiple method, then we are mixing the Discounted Cash Flow approach with the Relative Valuation Approach as the exit multiples is arrived from the comparable firms.
- Terminal value typical contributes more than 75% of the total value. This becomes a bit risky if you take into account the fact that Terminal Value varies a lot with even 1% change in WACC or Growth Rates.
- There can be companies like Box, which demonstrate negative Free Cash Flow to Firm. In this case, none of the three approaches to calculate Terminal Value will work. This implies that you cannot apply Discounted Cash Flow approach. The only way to value such a firm will be to use Relative valuation multiples.
- Growth Rate cannot be greater than WACC. If such is the case, then you cannot apply Perpetuity Growth Method to calculate Terminal Value.
Terminal Value is a very important concept in Discounted Cash Flows as it accounts for more than 60%-80% of the total valuation of the firm. You should put special attention in assuming the growth rates (g), discount rates (WACC) and the multiples (PE, Price to Book, PEG Ratio, EV/EBITDA or EV/EBIT). It is also helpful to calculate the terminal value using the two methods (perpetuity growth method and exit multiple method) and validate the assumptions used.
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