Valuation Tutorials

- Valuation Basics
- Discounted Cash Flows
- Going Concern concept
- Dividend Discount Model (DDM)
- Gordon Growth Model
- Discounted Cash Flow Analysis (DCF)
- Free Cash Flow to Firm (FCFF)
- Free Cash Flow to Equity (FCFE)
- Terminal Value
- Cost of Equity
- CAPM Beta
- Calculate Beta Coefficient
- Market Risk Premium
- Risk Premium formula
- Weighted Average Cost of Capital (WACC)
- Security Market Line (SML)
- Systematic Risk vs Unsystematic risk
- Free Cash Flow (FCF)
- Free Cash Flow Yield (FCFY)
- Mistakes in DCF
- Treasury Stock Method
- CAPM Formula
- Cash Flow vs Free Cash Flow
- Business Risk vs Financial risk
- Business Risk
- Financial Risk

- Valuation Multiples
- Equity Value vs Enterprise Value
- Trading Multiples
- Comparable Company Analysis
- Transaction Multiples
- (Price Earning Ratio (P/E)
- PE Ratio formula
- Price to Cash Flow (P/CF)
- Price to Book Value Ratio (P/B)
- Price To Book Value formula
- Price Earning Growth Ratio (PEG)
- Trailing PE vs Forward PE
- Forward PE
- EV to EBITDA Multiple
- EV to EBIT Ratio
- EV to Sales Ratio
- EV to Assets

- Other Valuation Tools
- Valuation Interview Prep

## What is Terminal Value?

**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 preparing Financial Model in excel. –

- Calculate Terminal Value?
- Steps in Calculating Terminal Value
- Formula
- Perpetuity Growth & Exit Multiple Method
- Excel Example
- Alibaba’s TV (using Perpetuity Growth Method)
- Can it ever be Negative?
- Limitations

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

Download Terminal Value Templates

### 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, macroeconomic 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

### Steps in Calculating 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 TV

- 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 Value of the Company (period beyond the Explicit Period)****Enterprise Value = Present alue (Explicit Period FCFF) + Present Value (TV)**- 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 terminal value 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 terminal value formula into two parts 1) Present Value of Explicit forecast 2) Present Value of TV

### 3 Types of Terminal Value Formulas

There are three formula for calculating 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 TV. 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.

#### 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 formula to calculate 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 terminal value 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 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 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 formula 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 TV 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

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

**Step 2 –** Calculate Terminal Value of the Stock (at the end of 2018) using 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 in this example, Terminal value contribution towards Enterprise value is 78%! This is no exception. Generally you will note that it contributes between 60-80% of the total value.

##### Share Price Calculation – using Exit Multiple Method

**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 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 TV of this stock.

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

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

Please note that in this example, TV **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 “TV”)

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

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

Step 3. Calculate the Net Present Value 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 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 terminal value formula above, 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 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.
- It typical contributes more than 75% of the total value. This becomes a bit risky if you take into account the fact that this 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 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.

### Conclusion

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 terminal value using the two methods (perpetuity growth method and exit multiple method) and validate the assumptions used.

### What’s Next?

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

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.

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