Formula to Calculate Terminal Value in DCF
Terminal value formula helps to estimate the value of a business beyond the explicit forecast period.
The terminal value includes the value of all cash flow even though it is not considered in that particular period. It is difficult to calculate the same with other financial models and hence, the terminal value formula is used. That’s why Terminal the value is the value of the company’s expected free cash flow beyond the period of the explicit projected financial model. The formula for the calculation of Terminal Value formula in DCF is as follows:
- T=Time
- WACC= Weighted average cost of capital or discounted rate.
- FCFF=Free cash flow to the firm
The terminal value is the present value of all future cash flow. It is mostly used in discounted cash flow analyses.
Calculation of Terminal Value
There are 3 methods for terminal value calculation, they are as follows:-
- Perpetuity Growth Method
- Exit Multiple Growth Method
- No growth perpetual model
#1 – Perpetuity Growth Method
Perpetual Growth Method is also known as the Gordon Growth Perpetual Model, This is the most preferred method. In this method, the assumption is made that the growth of the company will continue and return on capital will be more than the cost of capital.
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,
This method is used for companies that are mature in the market and have stable growth company Eg. FMCG companies, 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 enterprises’ value/ EBITDA or enterprise value/EBIT, which are the usual multiples used in financial valuation. The projected statistic is the relevant statistic projected in the previous year.
#3 – No Growth Perpetuity Model
No growth perpetuity formula used in industry where a lot of competition is there and the opportunity to earn excess return tends to move to zero. In this formula assumption is the growth rate is equal to zero, this means that the return on investment will be equal to the cost of capital.
Eg. It is useful to calculate the GDP of the country.
Examples
Example #1
If the metal sector is trading at 10 times the EV/EBITDA multiple, then the terminal value is 10 * EBITDA of the company.
Suppose,
- WACC = 10%
- Growth Rate = 4%
- Debit = $100
- Cash = $60
- Number of Shares = 200
Find the per share fair value of the stock using the two proposed terminal value calculation method
Terminal Value Calculation – Using the Perpetuity Growth Method
- Step #1 – Calculate the NPV of the Free Cash Flow to Firm for the explicit forecast period (2014-2018)
The formula for Present Value of Explicit FCFF is NPV() function in excel.
$127 is the net present value of period 2018 to 2020.
- Step #2 – Terminal Value calculation (at the end of 2018) using the Perpetuity Growth method
Using the Perpetuity Growth method Terminal Value will be: 1,040
- Step #3 – Present Value of Explicit FCFF
- Step #4 – Now, Calculate the Enterprise Value and the Share Price
Please note that in this example, the Terminal value contribution to enterprise value is 86%. Generally, the contribution is between 80 – 90%.
Terminal Value Calculation – Using Exit Multiple Growth Method
- Step #1 – For the explicit forecast period (2018-2020) calculate the Free Cash Flow NPV for the firm. Please refer to the above method, where this step has already been completed.
- Step #2 – Use the exit multiple methods for terminal value calculation of the stock (end of 2018). Let us assume that the average companies in this industry trade at 7 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%.
Example #2
There is a company with cash flow as $100, time i.e. n=5, DCF value will be $565 Million.
- DCF = 100 / (1+.1)1 + 100 / (1+.1)2 + 100 / (1+.1)3 + 100 / (1+.1)4 + 300 / (1+.1)5
- DCF = 91 + 83 + 75 + 68 + 62+ 186
- DCF = $565
Here, 300 / (1+0.1)5 which is equal to 186 is terminal value.
DCF formula tells if one pays less than DCF value, a rate of interest will be higher than the discounted rate, if one pays more than DCF value, the rate of interest will be lower than the discount rate.
When one analyzes potential investment he has to consider the time value of money in order to derive the rate of return over investment.
Relevance and Uses
- Use in a financial tool like the Gordon growth method.
- To calculate discounted cash flow example 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 value of the company. Special attention should be given in assuming the growth rates, discount rate and multiples like PE, Price to book, PEG ratio, EV/EBITDA, EV/EBIT, etc.
There are some limitations of terminal value in discounted cash flow, if we use exit multiple methods, then we are mixing the DCF approach with a relative valuation approach as the exit multiple is arrived from the comparable firm. Please note growth cannot be greater than the discounted rate. In that case, one cannot apply the Perpetuity growth method. Terminal value contributes more than 75% of the total value this became risky if value varies a lot with even a 1% change in growth rate or WACC.
Terminal Value Formula Video
Recommended Articles
This has been 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 & downloadable excel template. You may learn more about Valuations from the following articles –
