Suppose your friend has invested in a company’s stocks, made a handsome profit through it, and you also got inspired and motivated by his success in stocks. Therefore, you also decided to invest in the same firm’s stock for a long time without knowing about the company. You made a profit for a few months, and you thought everything was on track, but after a few months, you started to face setbacks in your stock investment and lost a significant portion of it. Now, most chances would be that you will never invest in stocks in the future.
The learning is that earning profits in the stock market will be difficult for you without having technical knowledge and the company’s long-term growth potential and vision. To make this easier for you, this brief guide will reflect on the importance and usage of the term Terminal Value in understanding the long-term growth potential of a corporate and the consequent profits derived thereof.
Terminal Value Meaning
Forecasting has been a basic human instinct from the beginning of human civilization, but it gets murkier as time progresses. It holds even in the financial world as well, mainly when estimating the company’s future cash flows.
So, Terminal Value is the value of an asset, business, or project beyond the forecasted period, when the future cash flows can be estimated. The Terminal Value here assumes that business will grow at a set growth rate forever after the forecasted period and often comprises a large percentage of the total assessed value. The Terminal Value is also known as the”continuing value” or “horizon value.”
Now let’s check out how to calculate the Terminal Value with the help of a formula.
Terminal Value Formula & Calculation
Formula:
Terminal Value is mathematically represented as:-
Terminal Value= (FCF*(1+g))/d-g
FCF=Forecasted Cash Flow
d= discount rate
g= terminal growth value.
Calculation:
Now let’s check out the following step-by-step process to calculate the Terminal Value:
There are three ways to calculate the Terminal Value of the company. The first two assume that the company will remain on a going concern basis while estimating TV. But the third approach assumes that a large corporation will take over the firm. Let’s look at this detail one by one.
1- Perpetuity Growth Model
This method is also known as the Gordon Growth Method. This method assumes that the company’s growth will continue (at a stable growth rate), and the return on capital will be more than the cost of capital. In this method, we discount the Free cash flow to the firm beyond the projected years to find the terminal value.
The formula to calculate the Terminal Value through Perpetuity Growth Model is:
Terminal Value= FCFF5*(1+growth rate)/(WACC-growth rate).
2- Exit Multiple Method.
An exit multiple calculates the Terminal Value in discounted cash flow formula to value a business. This method can determine the value of the business at the end of the project. The assumption is based on the existing public market valuation of comparable companies. Moreover, the most common multiple used in this method is EV/EBITDA or EV/EBIT.
This method assumes that a market with multiple bases is a fair way to value a business. Here, the firm’s value is obtained by multiplying financial metrics such as EBITDA or EBIT by a factor obtained from comparable companies. An appropriate range of multiples can be generated by looking at the recent acquisition in the market.
The multiple obtained here is then multiplied by the project EBIT or EBITDA in year N (the final year of the projected period) to give future value at the end of year n. The company’s terminal value or the future value is then discounted back using the company’s Weighted average cost of capital.
The value obtained here is then added to the Present value of FCC to determine the implied enterprise value. For the cyclical businesses where the business fluctuates along with the variation in the economy, here we use average EBIT or EBITDA.
Terminal Value= EBITDAn * Exit Multiple.
3- No Growth Perpetuity Method:
The method used in industries with a lot of competition and opportunities to make excess returns tend to be zero. In the No Growth Perpetuity Method formula, the growth rate equals zero, meaning the investment return will equal the cost of capital.
Terminal Value Formula= FCFF6*WACC
Example:
Now, let’s understand the concept through the example of Adani Group. The Group wants to estimate the value of one of its subsidiaries, Adani Power. Its financial team has decided to use the Perpetuity growth method to estimate the future value of the subsidiary. The economic team put the growth rate at 3% in perpetuity per annum, and free cash flow was estimated to be Rs. 150,000,000 at the end of the forecasted fifth year. The WACC or discount rate is 10%.
From the data given above, we can identify the following:
Terminal Value= unknown
Forecasted free cash flow= Rs. 150,000,000
Growth rate=3%
Discount rate 10%
Now we can substitute the value by using a formula.
Terminal Value= (FCF*(1+g))/d-g
TV= 150,000,000(1+(3/100))/10/100-3/100
Terminal Value= Rs. 58,200,000
Limitations:
- The perpetuity growth model assumes the discount rate and growth rate, and even the slightest inaccuracy in these rates can lead to improper results. Also, these rates change yearly, and this model does not take care of these aspects.
- The growth rate can be higher than the discount rate or weighted average cost of capital for some time. In these circumstances, the Terminal Value calculation gives negative or wrong results. Also, companies can show a negative free cash flow; hence the data can go wrong with the perpetuity growth model.
- In the Exit Multiple Method, the multiples change with time. Hence, choosing a correct multiple becomes a challenge here.
Conclusion:
Despite all its flaws and limitations, Terminal Value is still an easy and straightforward way to check the company’s future forecast. The Terminal Value is very important in discounted cash flow of the company as it accounts for a considerable 60-80% of the total valuation. So here, you should pay special attention to the growth and discount rates.
Leave a Reply