How can you determine the terminal value in a DCF analysis?

1 Perpetual growth method

The perpetual growth method assumes that the cash flows of the company or project will grow at a constant rate forever. This rate is usually based on the long-term growth rate of the economy, inflation, or the industry. To calculate the terminal value using this method, you need to apply the following formula: Terminal value = Final year cash flow * (1 + Growth rate) / (Discount rate - Growth rate) The discount rate is the rate of return that you require to invest in the company or project. It reflects the risk and opportunity cost of your investment. The growth rate should be lower than the discount rate, otherwise the terminal value will be infinite or negative.

2 Exit multiple method

The exit multiple method assumes that the company or project will be sold at the end of the forecast period, and its terminal value will be based on a multiple of a financial metric, such as earnings, revenue, or EBITDA. This multiple is usually derived from comparable companies or transactions in the same industry or sector. To calculate the terminal value using this method, you need to apply the following formula: Terminal value = Final year financial metric * Exit multiple The exit multiple should reflect the growth potential, profitability, and risk of the company or project. It should also be consistent with the financial metric that you use to estimate the cash flows.

3 Advantages and disadvantages

Both methods have their advantages and disadvantages. The perpetual growth method is simpler and more consistent with the DCF framework, but it relies on a single assumption that may not be realistic or stable over time. The exit multiple method is more flexible and aligned with market conditions, but it introduces a relative valuation element that may not capture the unique characteristics or synergies of the company or project.

4 How to choose a method

There is no definitive answer to which method is better or more accurate; the choice depends on the purpose and context of your valuation, as well as the availability and quality of data. Some factors to consider are the stage and life cycle of the company or project, the industry and market environment, and the sensitivity and robustness of your assumptions. For example, if a company is mature and stable, the perpetual growth method may be more appropriate. On the other hand, if there is a lot of uncertainty or disruption, the perpetual growth method may be too optimistic or pessimistic. Moreover, it is important to test how different growth rates, discount rates, exit multiples, and financial metrics affect your terminal value and overall valuation. Cross-checking your results with other methods or sources of information can also help you make an informed decision.

5 How to apply the terminal value

Once you have determined the terminal value using either method, you need to discount it to the present using the same discount rate that you used for the cash flows. Then, you need to add it to the present value of the cash flows to get the total value of the company or project. This is the basic formula for the DCF analysis: Value = Present value of cash flows + Present value of terminal value The terminal value usually represents a significant portion of the total value, so you should be careful and transparent about your assumptions and calculations. You should also remember that the terminal value is not a precise estimate, but a proxy for the infinite future of the company or project.