Terminal Value

What is the 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).

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.

Terminal Value

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

Download Terminal Value Templates

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Understanding Terminal Value

Terminal value is a key requirement of the Discounted Cash Flow.

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

Enterprise Value Formula

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Terminal Value Calculations

There is three ways to calculate 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 Model

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

This method is the preferred formula to calculate the Terminal Value of the firm. This method assumes that the growth of the company 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.

Terminal Value Formula - Perpetuity Method

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 companies that are mature, and the growth rate is relatively stable. An example could be mature companies in the automobile sector, the 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 calculation.

               Terminal Value = FCFF6 / WACC

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

#3 – Exit Multiple Method

This formula uses the underlying assumption that a market multiple bases is a fair approach to value a Business. 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 the metals and mining sector is trading at 8 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 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. Terminal Value Calculation Example

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 the Perpetuity Growth Method

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

Terminal Value Calculation Example - NPV FCFF

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

Terminal Value Calculation Example - Perpetuity Growth method

Step 3 – Calculate the Present Value of the TV

Terminal Value Calculation Example - Perpetuity Growth method - Present value

Step 4 – Calculate the Enterprise Value and the Share Price

Share Price using Perpetuity Growth method

Please note that in this example, the Terminal value contribution towards Enterprise value is 78%! 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 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 the 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.

Terminal Value Calculation Example - Exit Multiple Method

Step 3 – Calculate the Present Value of the TV

Terminal Value Calculation Example - Exit Multiple Method - Present Value

Step 4 – Calculate the Enterprise Value and the Share Price

Share Price using Exit Multiple Method

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

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.

Alibaba Terminal Value

You may download Alibaba’s Financial Model from here. The below diagram details the free cash flow to the 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”)

Alibaba FCFF Terminal Value

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

Alibaba NPV of Explicit Cash Flows

Step 2 – Calculate 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 

Alibaba FCFF Terminal Value - Part 1

Step 3. 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.

Alibaba FCFF Terminal Value - Part 2 - NPV

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

Alibaba DCF Summary

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 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 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(?). Here also, you may land up in a situation where equity value may literally become closer to zero.

Limitations of Terminal Value

Terminal Value Video

 

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 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.

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!

Reader Interactions

Comments

  1. vero says

    GOD BLESS YU FOR SHARING VERY EDUCATIVE ARTICLE

  2. 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.

  3. 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

  4. WilliamZen says

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

    • Dheeraj Vaidya says

      Thanks William!

  5. Akshay says

    This is really very good and explained in simple way.

    • Dheeraj Vaidya says

      thanks Akshay!

  6. 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.

  7. 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

  8. Henry Ababio says

    Very practically intuitive and insightful articles, keep it up!

    • Dheeraj says

      thanks Henry :-)

  9. devashish says

    nice stuffs.. thanks dheeraj

    • Dheeraj says

      thanks Devashish!

  10. 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

  11. nitin says

    thanks dheeraj

  12. 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 :-)

  13. Siblee says

    Thanks. The concept is nicely drafted.

    • Dheeraj says

      Thanks Siblee!

  14. 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!

  15. 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!

  16. saed idris says

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

    Thank you.

  17. 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.

  18. 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!

  19. 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.

  20. 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.

  21. Shaikpalur Anwar Hussain says

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

  22. 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

  23. Sagar Shetty says

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

  24. 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

  25. 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.

  26. 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

  27. 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..:)

  28. 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

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