What are the best methods to estimate terminal value?

Terminal value is essentially the estimated value of a business at the end of a projected period. It relies on the assumptions of going concern. However, predicting precisely how long a business will last is challenging. Thus, the cash flows are projected for a finite number of years, generally known as the high-growth period. After the projected period, a stable growth rate, generally known as the perpetual growth rate, is used to estimate the perpetual cash flows for the business. These perpetual cash flows are then discounted to arrive at the terminal value of the business at the end of the forecast period.

The most preferred approach is the exit multiple method. However, it should be kept in mind that an exit multiple for a less mature business could not be applied. It is better to check similar transactions or publicly traded businesses to identify the exit multiple..

It is important to note that the terminal value should be calculated once the company has reached stability. Otherwise the H-model formula could be applied or the cash flows should be extended until the company reaches stability.

Exploring effective approaches for estimating terminal value is crucial in strategic financial planning. One method that's gaining traction involves projecting future cash flows and discounting them back to present value using a suitable discount rate. Another viable approach entails leveraging comparable company analysis or precedent transactions to derive a reasonable estimate. Additionally, incorporating sensitivity analysis can enhance the robustness of terminal value estimations by considering various scenarios and their potential impacts. Ultimately, the key lies in employing a combination of methodologies tailored to the specific industry, company dynamics, and prevailing market conditions for a more accurate assessment.

There are broadly three ways of calculating Terminal Value (or Value of a company in the stable growth period).The first two uses the going concern concept 1) Gordon Growth Method : Based on the fundamentals (income approach) and usually the most widely used. The biggest flaw in this method is that one needs to tie in the reinvestment rate with the growth assumed. Also the stable growth assumed should be linked to the currency of the valuation 2) Exit multiple method -> usually preferred by the advisors as its linked to the market. However as we all know that markets are not efficient hence the proxy may not be an ideal indicator 3) Liquidation value - Hardly used as the underlying assumption is that the company would close

The terminal value can be calculated on the basis of perpetual growth method by assuming a fixed growth rate at which the company would grow forever (This growth rate should be less than the economy growth rate and industry growth rate). To calculate the terminal value, the cash flow of the last forecast period is multiplied by the growth rate to account for the growth and it is discounted by a rate which is discount rate minus the assumed growth rate.

By using perpetual or Gordon growth method we assume the value of a company in the stable growth period. In my experience the important question to answer is when does a company enter the stable growth period (is it after 5 yrs, 10yrs or 15yrs). This should be determined by three factors: 1) Size of the company: a startup will enter the stable period later vs a large comp 2) Competitive advantage - a comp in semi-con domain will probably end in the stable period at a later stage rather than a healthcare medical devices comp. 3) How efficiently a company manages to generate returns of its invested capital ( ROIC) - i.e the difference between cost of capital and ROIC. Higher the difference , longer the competitive growth period

The perpetual growth method comes with an assumption that a company will be there forever and after the foreseeable future it will grow at a constant rate. This rate is generally considered to be lesser than long-term growth rate of the economy and sector given there is a business life cycle every business follows. To compute the terminal value - consider the cash flow as a GP series with the zero component of the series being the last projected cash flow. Therefore, the summation of an infinite GP series is calculated as CFn * (1+g)/(1-r)

This method assumes your business will continue to generate cash at a steady, 'sustainable' rate forever. It's a bit theoretical, but it's often preferred by academics. It uses a formula: Terminal Value = (Free Cash Flow in the final forecast year * (1 + growth rate)) / (Discount rate – growth rate). The key is choosing realistic numbers for your growth rate and discount rate. Tip: Think of a mature, stable company like Coca-Cola when using this method. Their growth may be slower, but it's more predictable, making it easier to estimate into the future.

Forecast free cash flows for a finite period, typically 5-10 years. Choose a conservative perpetual growth rate, often close to or slightly above inflation. Apply the growth rate beyond the forecast period to estimate future cash flows. Discount those cash flows back to present value using the company’s weighted average cost of capital (WACC).

This method is all about a potential sale. You multiply a financial metric (like EBITDA or revenue) by a relevant industry multiple. Think of it like using house sale prices in your neighborhood to estimate the value of your own house. The trick is finding accurate multiples, as these vary between industries. If tech companies in your sector usually sell for 5x their revenue, you can apply something similar. Tip: The exit multiple method is better for volatile companies, or ones where an eventual sale is more likely, like a startup aiming to be acquired.

Identify comparable companies and their current valuation multiples (e.g., EV/EBITDA). Apply these multiples to your company’s projected financial metrics at the end of the forecast period. Determine the company's value based on these industry multiples. Discount the calculated terminal value back to its present value using WACC.

This method used to be a popular approach to estimating terminal values. However, most valuation practitioners that I know of today are no longer adopting this method anymore. Reason? This method consists of both valuation (income approach) and pricing (exit multiples), which is somewhat confusing as I wonder if the preparer is performing a valuation exercise or pricing work.

Exploring the optimal avenues for calculating terminal value is a captivating endeavor. From my experience, one effective approach involves leveraging discounted cash flow analysis, considering perpetuity growth rates, and scrutinizing comparable company valuations. Additionally, integrating scenario analysis can offer invaluable insights into potential outcomes, enhancing the robustness of our estimations. Delving into these methodologies not only refines our financial acumen but also fortifies strategic decision-making processes. I'm eager to engage further and exchange insights on this compelling topic.

Review and adjust financial projections for realism and conservatism. Consider macroeconomic and industry-specific risks. Adjust for non-recurring items in financial statements. Apply discounts or premiums based on liquidity, marketability, and other factors.

Ensures financial projections are realistic and achievable. Reflects risks and uncertainties in valuation. Corrects for one-time items for a clearer financial picture. Aligns valuation with market conditions and company specifics.

While most of the time, a terminal value is used in a DCF, two scenarios where a terminal value might not be applicable: 1. If a company is being valued for liquidation/non-going concern, the focus is on the liquidation value of the assets. In this case, terminal value is not considered, as the business will not continue operating indefinitely. 2. For fixed-term investments or ventures with a specific end date, such as an SPV with a two-year construction project, a terminal value is not applicable because the business does not plan to operate beyond the fixed-term horizon.

When doing this analysis, you should always complete a sensitivity table which tells reader the dependency of the valuation estimate on the terminal value assumptions. It's also important to describe the percentage of the total enterprise value that is comprised of the terminal value.

When estimating terminal value, it's crucial to consider the broader economic environment and industry trends that may impact growth rates. For instance, the perpetual growth method assumes a stable growth rate, which may not hold true in rapidly changing industries. Conversely, the exit multiple method can be influenced by market sentiment and comparable company performance, making it essential to select appropriate benchmarks. Incorporating sensitivity analyses around terminal value assumptions can provide a more robust valuation framework, allowing stakeholders to understand potential risks and rewards.

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