## What Is Terminal Value?

Terminal Value is the value of a business or a project beyond the explicit forecast period wherein its present value cannot be calculated. It includes the value of all cash flows, regardless of duration, and is an important component of the discounted cash flow model (DCF).

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Source: Terminal Value (wallstreetmojo.com)

In DCF, the terminal value is the value of a company’s expected free cash flow beyond the period of an explicit projected financial model. You should pay special attention to assuming the growth rates (g), discount rates (WACC), and the multiples (PE ratioPE RatioThe 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. read more, 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 read more, 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.read more, EV/EBITDA, or EV/EBIT). It is also helpful to calculate the terminal value using the two methods (perpetuity growth method and exit multiple methods) and validate the assumptions used.

##### Table of contents

### Terminal Value Explained

**Useful Downloads – 1) Free Terminal Value Excel Templates (used in the post) and 2) Alibaba IPO TV Calculation Model**

In the field of investment and financial analysis, the term terminal value refers to the value of a business that is estimated at some point of time in the future. The **terminal value equation** show how much value an investment will be generating beyond the period of cash flow projections.

Terminal value is a crucial requirement of the Discounted Cash Flow. Terminal Value is a fundamental concept in Discounted Cash Flows, accounting for more than 60%-80% of the firm’s total valuation. It is a very important concept in Discounted Cash Flows as it accounts for more than 60%-80% of the firm’s total valuation.

It isn’t easy to project the company’s financial statements showing how they would develop over a longer period.

The confidence level of financial statement projection diminishes exponentially for years, which is way farther from today. Also, macroeconomicMacroeconomicMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read more conditions affecting the business and the country may change structurally.

Therefore, we simplify and use certain average assumptions to find the firm’s value beyond the forecast period (called “**Terminal Value”**) as provided by Financial ModelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more.

The **terminal value equation** often accounts for a a huge part of the investment value. But there are many assumptions that are made in the process. The analysts often do a number or sensitivity analysis to compare the valuation with the assumptions. It is also be be kept in mind that the choice of method will depend on the type of investment.

The following graph shows why we calculate Terminal Value in DCF.

### Terminal Value Explained in Video

**Assumptions**

In the process, a few assumptions are made to calculate the future value of an investment or business beyond a point of time, which have a significant impact on the valuation outcome. Let us study them in details.

**Growth rate**– The most important assumption is the growth rate that the investment is expected to acquire on a continuous basis. This is assumed based on the historical data or any other industry benchmark. In the Gordon Growth model, the growth is assumed to be constant.**Stability**– The concept also assumes that the business or investment is operating used stable conditions that are predictable on a long term basis. This signifies that any fluctuations of changes will not be accounted for.**Competitive advantage**– It is assumed that the business will continue to sustain its position in the market on a continuous basis, and sustain its growth and expansion.**Reasonable capital expenditure**– The**terminal value formula**assumes that the business will make a reasonable amount of capital expenditure that will not affect its operations in a negative way and the business will operate effectively.**Discount rate**– This will have to be selected very carefully. It is the rate of return that is expected from the investment. The concept assumes a consistent discount rate and risk profile.**Industry regulation**– This fact is assumed taking into account the current conditions and historical trends. The industrial growth and regulatory environment in which the company operates will affect the terminal value to a great extent.

Thus, the above assumptions are considered while utilizing the concept of **terminal value of a company**. The reliability of the value estimation depends on the accuracy level of the assumptions mentioned above.

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### How To Calculate?

There are three ways to calculate the Terminal Value of the Firm. The first two approaches assume that the company will exist on a going concernGoing ConcernAny analyst analyzing a company will be left to a basic assumption that the company does not go bankrupt or file a chapter 11 bankruptcy. This basic assumption allows the analyst to think that there is no immediate danger to the company. The company can operate until infinity is called the principle of going concern.read more basis at the time of estimation of TV. The third approach **terminal value formula** assumes the company is taken over by a larger corporation, thereby paying the acquisition price. Let us look at these approaches in detail.

#### #1 – Perpetuity Growth Model

Please remember that the assumption here is that of “going concerned.”

This method is the preferred formula to calculate the firm’s firm’s Terminal Value. This method assumes that the company’s growth will continue (stable growth rate), and the return on capital will be more than the cost of capital. We discount the Free cash flowCash 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).read more to the firm beyond the projected years and find the Terminal Value.

Using cool maths, we can simplify the formula as per below –

**Terminal Value Calculation = FCFF6 / (WACC – Growth Rate)**

Numerator of the above formula can also be written as **FCFF (6) = FCFF (5) x (1+ growth rate)**

The revised calculation of terminal value is as follows –

**Terminal Value = FCFF5 * (1+ Growth Rate) / (WACC – Growth Rate)**

A reasonable estimate of the stable growth rate here is the GDP growth rate of the country. Gordon Growth Method can be applied in mature companies, and the growth rate is relatively stable. An example could be mature companies in the automobile sector, the consumer goodsConsumer GoodsConsumer goods are the products purchased by the buyers for consumption and not for resale. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy.read more sector, etc.

#### #2 – No Growth Perpetuity Model

This formula 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 terminal value calculation.

**Terminal Value = FCFF6 / WACC**

This methodology may be useful in sectors where competition is high, and the opportunity to earn excess returns tends to move to zero.

#### #3 – Exit Multiple Method

This formula uses the underlying assumption that a market with multiple bases is a fair approach to value a Business. A value is typically determined as a multiple of EBIT or EBITDADetermined As A Multiple Of EBIT Or EBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business's performance with that of its competitors.read more. For cyclical businesses, instead of the EBITDA or EBIT amount at the end of year n, we use an average EBIT or EBITDA throughout a cycle. For example, if the metals and mining sector is trading at eight times the EV/EBITDA multipleEV/EBITDA MultipleEV 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.read more, then the company’s TV implied using this method would be 8 x the EBITDA of the company.

### Example

Let us understand the concept of **terminal value of a company** with the help of some suitable examples.

#### Example#1

In this example, we calculate the fair value of the stock using the two-terminal value calculation approaches discussed above.

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 methods.

**Share Price Calculation – using the Perpetuity Growth Method**

**Step 1 –** Calculate the NPV of the Free Cash Flow to the firm for the explicit forecast period (2014-2018)

**Step 2 –** Calculate the **Terminal Value of the Stock** (at the end of 2018) using the Perpetuity Growth method.

**Step 3 –** Calculate the Present Value of the TV

**Step 4 –** Calculate the Enterprise Value and the Share Price

Please note that the Terminal value contribution towards Enterprise value is 78% in this example! This is no exception. Generally, you will note that it contributes to 60-80% of the total value.

**Share Price Calculation – using the Exit Multiple Method**

**Step 1 –** Calculate the NPV of the Free Cash Flow to the 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 the Exit Multiple Method. Let us assume that the average companies are trading at a 7x EV/EBITDA multiple in this industry. Then, we can apply this very same multiple to find the TV in this stock.

**Step 3** – Calculate the Present Value of the TV

**Step 4 –** Calculate the Enterprise Value and the Share Price

Please note that TV **contribution towards Enterprise value is 77% in this example!**

With both 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 a large difference in share prices using the two methodologies.

#### Example#2

You may download Alibaba’s Financial Model from here. The below diagram details the free cash flow of the firm of Alibaba and the approach to finding a fair valuation of the firm.

**Valuation of Alibaba = **Present Value of FCFF (2015-2022) + Present Value of FCFF (2023 until infinite “TV”)

Step 1 – Calculate the NPV of the Free Cash flow to the firm Alibaba for the explicit period (2015-2022)

Step 2 – Calculate the Terminal value of Alibaba at the end of the year 2022 – In this DCF model, we have used the Perpetuity Growth method to calculate the Terminal Value of Alibaba.

Step 3. Calculate the Calculate the Net Present ValueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more of the TV.

Step 4 – Calculate the Enterprise Value and Fair Share Price of Alibaba

Please note that TV contributes approximately 72% of the total Enterprise Value in the case of Alibaba.

### Can You Get Negative Terminal Value?

Theoretically, YES, Practically NO!

Theoretically, this can happen when the Terminal value is calculated using the perpetuity growth method.

**Terminal Value = FCFF5 * (1+ Growth Rate) / (WACC – Growth Rate)**

In the above calculation, if we assume **WACC < growth rate**, then the 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 because of the formula used. However, this high growth rate assumption is incorrect. We cannot assume that a company will grow at a very high rate until it is infinite. If this is the case, this company will attract all the capital available in the world. Eventually, the company would become the entire economy, and everyone working for this company (Awesome! unfortunately, this is unlikely!)

When doing valuation, a negative terminal value practically doesn’t exist. However, if the company is in huge losses and goes bankrupt in the future, the equity value will become zero. Another cause could be if the company’s product is becoming obsolete, like the typewriters or pagers, or Blackberry(?). So you may also land up in a situation where equity value may become closer to zero.

### Limitations

Give below are some important limitations of the concept of **terminal value of a stock**. Let us study them in details.

- Please note that if we use the exit multiple methods, we are mixing the Discounted Cash Flow approach with the Relative Valuation Approach as the exit multiples have arrived from the comparable firms.
- It typically contributes more than 75% of the total value. This becomes a bit risky if you consider that this value varies a lot with even a 1% change in WACC or Growth Rates.
- Companies like BoxBoxThe analysis of the Box IPO valuation can be done using various methodologies which are Relative Valuation – SaaS Comparable Comps, Comparable Acquisition Analysis, Using Stock-Based Rewards, Valuation cues from Private Equity Funding, Valuation cues from Dropbox Private Equity Funding, and Discounted Cash Flow Approach for Box IPO Valuation.read more can demonstrate negative Free Cash Flow to the firm. In this case, none of the three approaches will work. This implies that you cannot apply a Discounted Cash Flow approach. The only way to value such a firm will be to use Relative valuation multiples.
- The growth rate cannot be greater than WACC. If such is the case, you cannot apply the Perpetuity Growth Method to calculate Terminal Value.

**Terminal Value Vs Instrumental Value**

Both the above are two different concepts frequently used in the field of ethics and finance.

- The former is used in the field on finance and investment for the purpose of analysis and valuation of business and investment. But the latter is associated with philosophy, ethics, or study of values.
- The former represents the value of an asset at a point of time in the future. But the latter represents something that is desirable or has a lot of value because it helps in achieving a goal.
- The former is calculated based on the expected cash flow’s future value whereas this is not the case with the latter.

Thus the above are some basic differences between the two concepts.

### What’s Next?

If you learned something new or enjoyed the post, please comment below. Let me know what you think. Many thanks, and take care. Happy Learning!

### Recommended Articles

The article has been a guide to what is Terminal Value. We explain how to calculate, examples, differences with instrumental value & if it can be negative.

vero says

GOD BLESS YU FOR SHARING VERY EDUCATIVE ARTICLE

Chan says

Hi Mr. Dheeraj, is there any circumstance where there is no terminal value at all?

Dheeraj Vaidya says

Yes Chan, it can happen that there is no terminal value at all. Think of a company that has been formed to execute a single project. In that case, cash flows will come only until the end of the project.

Amol says

Really very nice post

Stock values calculated through this method

I have done TCS modelling .

Now stockprice is 2630 Rs

with EV/EBIDTA method : 3589 Rs

Withperpetuity growth method : 4452 Rs

Is this right ?

or With modelling we have to get values close to current stok price ?

Dheeraj Vaidya says

Hi Amol,

It is not necessary that your values come closer to the current stock prices. It depends on your assumptions, your financial model etc.

Thanks,

Dheeraj

WilliamZen says

wow, awesome article post.Much thanks again. Fantastic.

Dheeraj Vaidya says

Thanks William!

Akshay says

This is really very good and explained in simple way.

Dheeraj Vaidya says

thanks Akshay!

suryanovi says

thanks dheeraj. what difference between continuing value than terminal value?

Dheeraj says

For me it is one and the same thing. Terminal vale represents the value of the firm assuming the company will exist forever.

kamel says

Thank you

Guillermo Muñoz says

Gracias, excelente página. ¿EL valor terminal es aplicable para la evaluación de nuevos proyectos o negocios de emprendimiento?

Dheeraj says

Hi Guillermo,

Yes Terminal value is also applicable to new projects and business ventures. Please note that primary assumption that we make for Terminal value is that the venture is going to continue “forever”

Thanks,

Dheeraj

ratika says

Hi Dheeraj,

Thanks for your blog! I have a model in which terminal value calculation has been incorporated. However, now we need to change the time-estimate from infinity to 30 years. The model already has all the computation for 10 years with terminal value. Is there a way where I can change the terminal calculation in such a way that it reflects the value of a finite period of 20 years only instead of perpetuity?

Thanks in Advance!

Dheeraj Vaidya says

Hi Ratika,

In this case, you need to apply a limited period Geometric Progression Formula. After 10 years, you will need to take the growth rate assumption for the FCFF for the next 20 years. Thereby you need to apply the Geometric Progression Formula

Terminal value (at the end of 10th year) = FCFF(10) x (1-r^n)/(1-r)

here, r = (1+g)/(1+WACC).

for more references regarding Geometric Formula, you can look at this

Hope it helps.

Best,

Dheeraj

alex Wang says

Thanks so much

Henry Ababio says

Very practically intuitive and insightful articles, keep it up!

Dheeraj says

thanks Henry :-)

devashish says

nice stuffs.. thanks dheeraj

Dheeraj says

thanks Devashish!

Hermanto says

Hi Dheeraj,

I am not a finance guy but I enjoy working financial modeling while helping my friend investment banker in analyzing the oil and gas asset valuation, I never used Terminal Value in oil and gas DCF calculation as oil and gas revenue or cash flow is absolutely driven by oil and gas reserve and or resource while non oil and gas or mining business are not dependent on limited or nonrenewable resources

Thanks anyway for great article

Hermanto

Dheeraj says

Thanks Hermanto. You are right, a terminal value calculation may not be required for oil and gas upstream companies as they are more asset based with limited useful life. The key here would be to project the total about of oil & gas available for extraction and the number of years.

Best,

Dheeraj

nitin says

thanks dheeraj

Jack says

Thanks for this. I was getting confused about the possibility of a growth rate being higher than WACC in a TV calculation and your explanation cleared it up for me.

Dheeraj says

Thank you Jack :-)

Siblee says

Thanks. The concept is nicely drafted.

Dheeraj says

Thanks Siblee!

Mohsin says

This was my first experience reading through this website, and I must admit that it was way too helpful for me. Thanks Dheeraj for your lovely and simple explanation on the topic.

Dheeraj says

Thanks Mohsin!

Minal N Shah says

Thanks Dheeraj.One of the best site for financial modelling i came across.Very well explained all the concepts.Very resourceful.Awaiting for more articles on Financial Modelling ,Valuations and also M&A.Step by Step explaination on Colgate Model was great.Appreciate many more such examples.

Dheeraj says

Thank you Minal!

saed idris says

I’m very happy because I got what I need in professional way.

Thank you.

bala subramanian says

an eye opener on valuations.excellent step by step article for the lame man.

i propose to apply this method to pick stocks of undervalued companies that are listed in the indian markets.

Dheeraj says

Many thanks Bala for your kind words. I am glad you found this useful.

Irina says

Hello! Thank you so much for this helpful site! Great job!

I would be grateful for your answer on a small question:

what input criteria have you used in Sensitivity Analysis of Alibaba DCF in you excel file? I’ve tried to come up with the same data set based on calculations on DCF sheet, but I couldn’t find the right input.

Thank you!

Nidhi Malik says

Hi Dheeraj, Your articles are really very helpful and the way you have explained all the concept is outstanding.. plz keep on sending such articles… if possible plz share articles related to valuation step by step for one company.

Muthoni says

great post! how do you validate you terminal growth rate and what approach do you use where?….there is what we have read theoretically g=ROE*retention rate and here you assume you growth rate as the GDP growth.If you ask me there some companies that grow faster than gdp or slower than gdp. Kindly explain.

Shaikpalur Anwar Hussain says

Concept and quants are fine but excel presentation may be a bit confusing for the new users like me.

mahendra edunoori says

i am always follows your tips regarding this articles… .

even this articles are very helpful in my studies, i can learn a lot from your articles. i glade to thanks you…. and even i expecting a many more articles……..

regards- mahendra

Sagar Shetty says

Hi dheeraj. Could you share some insights on Valuing A Company Using The Residual Income Method with an excel based example?

Arinjay says

Oh, I am overwhelmed with this sentence, i had worked on this Sir, but i have never thought from this perspective (Mathematics, although i am graduated in Mathematics) 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. Then I thought about this from capital market perspective like since it would be the whole economy and it will attract whole capital so from other companies perspective the whole market would be dried up…… I have learned this ne

w thing from your post. Thank you very much for updation

C.K.sathiish says

Thank you Mr.Dheeraj,

Its a thought provoking experience while analyzing your models. Am working for power sector, please post financing structures and investment analysis with spread sheets.

Thanks a lot.

Warm Regards,

C.K.Sathiish,

Analyst-Project Finance

PPP power projects, India.

Wall Street Mojo says

Thank you Sathiish! Sure, i look forward to sharing more spreadsheets on Financial Models across sectors.

vaibhav choudhary says

hey..dheeraj ..keep sending these concepts which are realy useful in the practical world.It is always a learning experience reading your post.Keeping sending them.I am more than thankful to you.

Wall Street Mojo says

Thanks Vaibhav, I do intend to write frequently on such topics on valuations and financial modeling.

Best, Dheeraj

Mona says

Very well put.

I have been following your articles and i have liked and shared them all.

You seem to have done loads of research on Alibaba IPO..:)

Andrew says

This is an awesome primer on Terminal Value. Thanks Dheeraj

Wall Street Mojo says

My pleasure Andrew. I am glad you liked the article.

Best, Dheeraj