Terminal Value

What is “Terminal Value”?

Discounted cash flows (DCF) are a powerful tool for determining the value of a financial instrument. With forecast cashflows and the appropriate discount rate, it’s possible to value companies, stocks, bonds, and many other financial instruments. However, there’s an issue when you get to the distant future. Rather than forecast individual cashflows anticipated in 10+ years, a series of endless cashflows known as perpetuity is used. This is convenient as all cashflows from year 11 to infinity can be dealt with in one calculation, called the terminal value, but it comes with a price.

A huge part of the DCF value is now wrapped up in one very sensitive calculation, the terminal value (TV). Small changes to the inputs can mean huge changes to the output. Everyone working in financial services and conducting DCF valuations should be aware of how sensitive TV can be and know how to use it accordingly. Better valuations and better investment decisions will follow.

Consider the following company (the file is available in the downloads section if you’d like to browse the whole model):

The modeler has created a three-year forecast. They’ve used some sensible (if simple!) assumptions and ended up with EBITDA figures. However, EBITDA isn’t something you should be discounting. The next step is generating free cash flows (FCF), which are compatible with the weighted average cost of capital (WACC) to determine present value (PV). Notice the starting point is the EBITDA from the income statement above.

Once discounted, the FCFs for years 1-3 represent the valuation of the explicit forecast period. If the company were to shut down in year three that would be its entire value, but that’s not realistic. The company will continue to make money and probably grow. The TV will assume this growth will go on forever. You might argue that this is just as unrealistic as the company shutting down after three years; however, there are two strong arguments for this approach:

1. Most successful companies will have a life well beyond the explicit forecast period
2. Because of the way discounting works, very distant cashflows don’t matter as much. If the company were to shut down in 70 years’ time cashflows beyond that would be immaterial to the value today

The combination of these two ideas means that valuers are comfortable using an assumption that free cashflows will continue forever. The value beyond the five years in the model is called the terminal value.

Terminal Value: Are We There Yet?

It’s tempting to give a blanket rule for terminal value. For example, you could say that all models should run for five years, and then switch over to terminal value. This approach risks creating a bad valuation. The way we approach terminal value may reduce the model from around 100 rows of moving pieces to about 3, a big reduction in detail. This is possible because the company is assumed to be

In this case, the two phases are clear because the patent creates a clear transition. However, even for this company, there’s a decision to be made. The patent expires in five years, but the company will probably enjoy an ensuing period with a strong market position. The explicit forecast period will probably need to continue for some time, probably until year 10, and only after that do we predict stable growth.

Terminal Value Model Tests

So, how do we make that judgment call? Ideally, several checks should be performed on the model as it approaches the proposed end of the explicit forecast period:

Revenue growth	Should match long-term growth (used in the growth perpetuity) by the final year. If not there’s a mismatch between the growth (and reinvestment) in the final FCF and the subsequent growth that’s predicted in the perpetuity
Margins	Should be stable. If margins are stable, and growth is stable, then earnings growth is also stable
Return on invested capital (NOPAT/(equity + net debt))	Should be stabilizing and be close to the WACC. A maturing company should have margins stabilizing towards a lower rate, which should produce a return on invested capital close to the cost of capital. Caution should be used when analyzing companies which have a lot of intangibles though. For example, a lot of Red Bull’s value is in its brand, which isn’t on the balance sheet
Cash conversion (FCF/NOPAT)	This should be rising and then stabilizing. As the company is maturing it doesn’t need to invest as much to grow. This means more profits turn into cashflows
Invested capital growth	Should be equal to revenue growth. This brings together a lot of the above logic. If revenue growth, margins and ROIC are stable, then you should see revenue start to filter through to earnings and then either cash or invested capital in a highly predictable way.

If these tests are failed, then it’s a good indication that the company has not reached a steady state yet. There are several ways of dealing with this.

1. Change the model

The model may need some work on its assumptions or may need to add some years. For example, you can see below a firm whose revenue growth is too high going into the final year compared to its long-term growth. It’s probably because the explicit forecast period is too short, so it’s tempting to keep growth very high right up until the final year.

Having final year revenue growth that is high means the final free cash flow contains some movements, which we don’t want. For example, high revenue growth may mean investment in working capital (often linked to revenue in models). If we base the TV calculation on this FCF we’re predicting low sustained growth going forward but linking it with a cash flow that’s supporting high growth.

Adding years and bringing growth down gradually over the years would help this model. If you’d like to see how that works, with commentary, see the attached download.

2. Add a terminus

You may not want to forecast additional years. To avoid this, some analysts add an altered year (also called a terminus) to the end of the explicit forecast. This extra year may be the next year, or a recast version of the final year. This extra year can be useful as variables can be changed to force the TV tests to be passed. For example, setting working capital movements and capital expenditure to be in line with revenue growth. To reduce detail even more, the model may not forecast working capital movements or capex at all; it may just forecast invested capital movements.

The perpetuity can then be safely based on this altered year. This will pull ROIC and other assumptions into alignment even if the last explicit forecast year wasn’t representative. Note that care would need to be taken with the growth perpetuity formula when using a terminus. If the terminus is a recast final year, then the growth perpetuity would need a (1+g) on top. If the terminus is the next year, then the growth perpetuity would not need a (1+g). There’s more detail on how growth perpetuities work later in the blog, which may help you understand why a (1+g) plays a role here.

See the example below where there appear to be two final years. Although it looks like double counting, the final year is purely a calculation upon which the terminal value is based:

Also, note that some detail seems to be missing in the terminus. This is due to the simplifying approach discussed above. Operating working capital doesn’t matter when you’re simplifying down to invested capital as a single figure. If you’d like to see how the terminus works in detail, with commentary, see the attached download.

3. Fade

Other analysts choose to ‘fade’ towards a steady state. They may have a very long DCF, maybe 20 years. However, only a small number of those years will have explicit forecasts in them. The rest of the DCF will have key assumptions such as revenue growth and ROIC gradually moving towards a mature state. For example, below you can see a formula that helps the model gradually move between the revenue growth at the end of the explicit forecast and the long-term growth required for the TV. The example below is 28 years into a forecast, so to see the full picture we’d encourage you to have a look at the model in the download section.

This may be useful for valuing companies with a long period of competitive advantage, but where you are unwilling to forecast explicitly for that long. The example of a pharmaceutical company used earlier works well here. They are likely to earn good returns while their patent is in force, and their patent may be a very long one. However, you may be unwilling to make explicit forecasts that far out.

Whatever method you use you should be satisfied a steady state has been reached. If so, you’re ready to start calculating the terminal value.

Methods for Calculating Present Value of Terminal Value

Method one: Growth perpetuity

A growth perpetuity can be used to create the terminal value. It’s typically calculated first by bringing the value to the final year (orange below), then discounted back to the valuation date (green below).

The formula used is

Where CF is the first cashflow in the perpetual series of cashflows (which run after the explicit period cash flows). This means that if you base the perpetuity on the final explicit period FCF, you need to add a (1+g) to forecast the first cashflow in the perpetuity.

Advantages	Disadvantages
Uses the same inputs as the model, so is easily sense-checked against the model. Growth can be checked against revenue growth. WACC can be checked against ROIC	Can lead to poor valuations if checking isn’t done properly

Growing perpetuity assumptions and the value driver model

There is another way of looking at a growing perpetuity, that may help to improve the robustness of the assumptions used for terminal value. By rearranging several formulae you can get to the following:

Notice the basic perpetuity formula is still there, but ROIC has appeared. The useful thing about this is that the value driver model considers the reinvestment needed to drive growth. In a growing perpetuity the reinvestment is baked into the final FCF. This means the user needs to be careful to avoid a badly conceived FCF which, for example, doesn’t have enough reinvestment to support revenue growth. Or, on the other hand, has too much reinvestment because the final year FCF has too high a revenue growth compared to the long-term growth factor.

Careful use of the value driver model may help to avoid some of the issues of a growing perpetuity. However, it’s not as widely used as the growth perpetuity.

Method two: Terminal value multiple

It’s possible to use a multiple to value the terminal period instead. EV/EBITDA is commonly used. The terminal EBITDA is multiplied by the multiple. This means the terminal value calculation is a lot like using trading comparables (see our blog on trading comps This multiple therefore needs to be consistent with the multiples of companies which have current growth expectations like the terminal growth rate of the target company.

Notice one of the elements used in the perpetuity formula is clearly present. Cash/earnings is clearly represented by EBITDA. However, growth and the cost of capital aren’t as clear. They’re contained in the multiple, which acts like a growing perpetuity factor 1/(wacc-g).

Advantages	Disadvantages
Multiples are readily understood by investment banking professionals who may work with them daily	Multiples further simplify the inputs, meaning it’s even more sensitive to change
Teams may have access to sector experts who have good experience in in providing a suitable, sector-appropriate terminal multiple	The multiple would need to reflect a steady state. Finding a comparable company to base this on can be challenging

Timing of multiples

Depending on the multiples used, it’s possible to create a problem in your valuation by having a mismatch in the timing of your multiple and your valuation. Imagine you want to use multiples to get the terminal value of the company we’ve been seeing throughout the blog. Imagine the valuation is taking place in 2023.

• The valuation date would be 1/1/23
• The last explicit forecast may be 3 years later, 31/12/25
• The last EBITDA in that forecast would be for the year ended 31/12/25
• The terminal value would stand at the end of 25 initially, before being discounted to 1/1/23

The below graphic relates these ideas to the model we’ve been using throughout.

Using the first multiple, a forward multiple, creates problems:

1. The value point is now mid-year. Our model has a final EBITDA of Dec 25. Using this midyear multiple would bring the terminal value to Jun 25. This would mean some awkward discounting to get back to Jan 23
2. The relationship of EV/EBITDA is skewed. As the year progresses the company will be turning its income into assets which will turn up in the EV. By June you would be basing your EV on the nearest quarterly results. This would mean a different relationship of EV and EBITDA to other points in the year

This means the use of LTM multiples rather than forward multiples is encouraged.

Conclusion

DCF is a widely used valuation method. It’s particularly important in valuing start-ups, or where there’s a lack of close public peers to drive other valuation techniques. TV is a large part of the value in DCF. This means TV should be handled with care. Whatever method your organization uses to calculate TV you should be aware of the potential pitfalls. This will help you to create robust valuations.

If you’d like to find out more about DCF, including building free cashflows, calculating the WACC, and using the tests discussed above, consider Financial Edge’s course the valuer.

If you’re interested in this level of detail in the DCF it’s quite possible you’d be interested in our research analyst course. It’s an in-depth look at accounting, modeling and valuation from the perspective of a research analyst.