How do you determine the terminal value of a business?

1 Perpetual growth model

The perpetual growth model assumes that the business will grow at a constant rate forever, and applies a formula to calculate the present value of the future cash flows. The formula is: Terminal value = Free cash flow * (1 + Growth rate) / (Discount rate - Growth rate) To use this model, you need to estimate the free cash flow, the growth rate, and the discount rate of the business. The free cash flow is the cash generated by the business after deducting capital expenditures and working capital needs. The growth rate is the expected annual increase in the free cash flow, which should be lower than the discount rate and the economy's growth rate. The discount rate is the required rate of return for investing in the business, which reflects the risk and opportunity cost.

2 Exit multiple model

The exit multiple model assumes that the business will be sold at the end of the forecast period, and applies a multiple to the projected earnings or cash flow of the business. The multiple is usually based on the market value of comparable businesses or transactions. The formula is: Terminal value = Earnings or cash flow * Multiple To use this model, you need to estimate the earnings or cash flow, and the multiple of the business. The earnings or cash flow can be based on different measures, such as EBITDA, EBIT, or net income. The multiple can be derived from the average or median multiples of similar businesses or transactions in the same industry or sector.

3 Advantages and disadvantages

Both models have advantages and disadvantages, and the choice depends on the nature and purpose of the valuation. The perpetual growth model is simpler and more consistent, but it can be sensitive to the assumptions of the growth rate and the discount rate. The exit multiple model is more realistic and flexible, but it can be subjective and volatile to the market conditions and the availability of comparable data.

4 Sensitivity analysis

Because the terminal value is based on uncertain assumptions and projections, it is important to perform a sensitivity analysis to test how the terminal value changes with different scenarios and variables. A sensitivity analysis can help you identify the key drivers and risks of the terminal value, and provide a range of possible values instead of a single point estimate.

5 Best practices

To accurately and reliably determine the terminal value of a business, you should follow some best practices. It is important to use both models and compare the results for consistency and reasonableness, as well as use conservative and realistic assumptions that reflect industry and market trends. Furthermore, it is essential to use multiple sources of data and information to support your assumptions and calculations. Additionally, you should document and explain your methodology and assumptions clearly and transparently, while also reviewing and updating your terminal value periodically. Ultimately, determining the terminal value of a business is a complex task that requires careful analysis and judgment; however, by using the appropriate models and methods, you can estimate it with confidence and credibility.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?