What is Terminal Value Formula?
The terminal value formula helps in estimating the value of a business beyond the explicit forecast period. In a DCF model with a 5 year free cash flow projections, the terminal value formula = FCFF6 / (WACC – Growth Rate)
3 Most Common Terminal Value Formulas
In DCF Valuation, there are 3 ways in which you can find terminal value. they are as follows:-
- Perpetuity Growth Method
- Exit Multiple Growth Method
- No Growth Perpetuity model
#1 – Perpetuity Growth Method
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. . 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 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. 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 is 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.
If the metal sector is trading at 10 times the EV/EBITDA multiple, then the terminal value is 10 * EBITDA of the company.
- 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
Application of Terminal Value Formulas
#1 – Terminal Value – Using the Perpetuity Growth Method
Follow the steps below to find terminal value using the perpetuity growth method:
- Calculate the NPV of the Free Cash Flow to 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 of 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 in this example, the Terminal value contribution to enterprise value is 86%. Generally, the contribution is between 80 – 90%.
#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). 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%.
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 company’s worth. Special attention should be given in 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. , 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 , 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., 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
This article 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 & a downloadable excel template. You may learn more about Valuations from the following articles –