What is “Terminal Value”?
Terminal value plays a crucial role in discounted cash flow (DCF) analysis. A key principle of the DCF method is to discount a businesses’ future cash flows to arrive at its enterprise value. While it is possible to forecast future cash flows for the next 5 or 10 years to steady state, beyond that it is impractical and the likelihood of the forecast being accurate is low.
Terminal value summarizes the value of steady state cash flows beyond the set forecast period in the DCF (which is usually 5 or 10 years). Thus this is often from year 6 or year 11 to infinity depending on the data available. This period is known as the “steady state” time frame. A company reaches “steady state” when all sources of competitive advantage are exhausted, and its profitability and efficiency ratios are stabilized. This means that it is mature and hopefully producing returns marginally above those required by investors.
Key Learning Points
- Terminal Value calculates the steady state cash flows AFTER the 5 or 10 year cash flows for DCF analysis
- Enterprise Value equals the present value sum of future explicit free cash flows and the terminal value
- Terminal Value represents a majority proportion of a company’s enterprise value
- It is preferable to forecast a company’s free cash flows at least 5 years or longer into the future depending on the data available
- The long-run free cash flow growth rate is a key assumption used in calculating the terminal value and even small changes to this assumption can cause large variances in the value calculated
- There are two methods used to calculate the terminal value: growing perpetuity and multiple method
Methods To Calculate Terminal Value
The company will grow at a low consistent rate during the steady state period. One of the elements of this analysis is the Weighted Average Cost of Capital (WACC), which calculates the cost of capital based on their proportionate weights (e.g. 60% equity, 40% debt.) Here is the formula to calculate the terminal value using the growing perpetuity approach:
Terminal Value (TVn) = Free Cash Flow (FCF)n * (1+g)/(w-g)
TVn = Terminal value
FCFn = Free cash flows in the final year of forecasting
w = Weighted Average Cost of Capital (WACC)
g = Growth rate in perpetuity
Let us understand this with an example:
What is the terminal value of this business?
Using the formula above, you get the following:
The Terminal Value of this business is 12.75 million:
In this method, you take the company’s EBIT or EBITDA in the final year of the forecast period (year 6 or 11) and multiply that by a comparable company’s Enterprise Value (EV) to EBITDA multiple. The EV/EBITDA is a useful ratio for comparing companies within a sector or peer group. The formula used in this approach is:
Terminal Value (TVn) = LTM EBITDAn * Multiple
TVn = Terminal value
LTM EBITDAn= Last 12 months EBITDA until year 5
Multiple = Based on EV/EBITDA ratio from a company (within the same industry) that has reached a steady state
Let us understand this with another example. Suppose the business has an LTM EBITDAn of 500,000. And using data from comparable companies, assume you get an EV/EBITDA multiple of 9.0x. What is the terminal value of this business?
Using the EV multiples approach, the terminal value of this business is $4.5 million.
Factors to be Considered to Determine Steady State
The Terminal Value represents a significant proportion of the company’s value. Therefore, the Terminal Value can have a significant impact on the final valuation. If the terminal value is unreasonably high, it can lead to overvaluing a business, and vice versa. To arrive at an appropriate terminal value, a key decision is determining the beginning of the steady-state period.
Let us look at some factors that can help in reaching a reliable Terminal Value:
Effective Tax Rate Approaches the Marginal Tax Rate
In the growing stages of a company, there is a substantial difference between these two tax rates due to factors like deferred tax assets/liabilities, differences in depreciation methodologies between the company and tax authorities, etc. But as a company matures, these differences start to erode, and the effective tax rate starts to approach the marginal tax rate.
At the growth stage, a company can charge premium prices, leading to higher margins. But as a company matures, competition catches up and this leads to a reduction in margins. Once the margins have stabilized, it is a good indication to start the steady-state period.
Returns Close to WACC
Similar to margins, in the early stages a business generates higher returns as compared to WACC. For example, if the WACC is 8%, a business may generate returns of 20%. But as the business matures, the gap between returns and WACC narrows down.
Sound Long-term Capital Structure
For a startup with unpredictable cash flows, it can be hard to get debt at lower rates due to the high perceived risk of an unproven start-up business. But once the cash flow generation stabilizes, a business can gain access to cheaper forms of finance (as the perceived risk falls). One way to test this stage is when the long-term capital structure (the mix between debt and equity) is closer to the industry average.
Narrowing Gap Between Growth and Long-Term Inflation
The steady state period is likely to continue to infinity. While the initial stages of a business may see high growth, such growth is not sustainable over the long term. Eventually, the growth rate falls away and comes closer to inflation. To give an example, in the initial stages a business may grow at 30% a year, while inflation is 2%. However, as the business matures, it will grow at a rate of 8%, which is much closer to the inflation rate.
Stable CapEx & Free Cash Flows
As a business matures, it may not have to undertake such heavy investments or capital expenditures as it did in the early stages to fund its expansion. This means the business can retain a higher portion of profits, resulting in stable free cash flows.