Terminal Value Explained

Terminal Value Explained

The terminal value is the value of the company’s expected cash flow beyond the explicit forecast horizon. A high-quality estimate of terminal value is critical because it often accounts for a large percentage of the total value of the company in a discounted cash flow valuation.

As a result, all financial analysts should be familiar with the mechanics of terminal value and how it is calculated in order to ensure an accurate financial modeling and valuation exercise.

Look at the illustration below, which shows the various ways in which terminal value can be calculated:

Terminal Value

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5 Responses to “Terminal Value Explained”

  1. How would you use P/E as a multiple for terminal? I’ve seen TEV/EBITDA, and a few others, but never earnings multiple, considering you didn’t really use earnings, you used FCF. As well, if you are getting P, you need to take into account the fact it is just equity, not enterprise value.

  2. Thanks for your comments. You are correct to point out that it is not “exactly right” to use P/E multiple to derive a terminal value.

    However the overall multiples approach to calculating terminal value can sometimes be flawed, as using multiples estimated from comparable businesses results in a dangerous mix of relative valuation and intrinsic valuation. However using multiples derived fundamentally should theoretically be OK.

    Nonetheless the multiples approach to terminal value continues to be used and valued for its simplicity and providing relatively robust ball-park estimates.

    Besides the P/E multiple to earnings approach, other methods even apply multiples to revenue to derive terminal value (used often to value early-stage technology companies).

    More consistent and conservative ways of estimating terminal value in a financial model would be to use either of the perpetuity models cited above.

    For all approaches used to derive terminal value, it will be prudent to use a range of discount rates, multiples and growth rates to establish a valuation range instead of a single number.

  3. Hi,

    I could be wrong here, but I believe you can even utilise an EV/EBITDA to obtain a terminal value. For eg – If the terminal year is FY 2013 & the EBITDA in that year is $100, an EV/EBITDA of 7 would give the firm a Terminal value of $700 (of course, you would have to discount this backwards to account for PV)

  4. generally in valuation, terminal value represents what percentage of total value?

  5. […] initial capital outlay, the cash flows attained from implementing / investing in the project, the terminal value or cost, and the scale and timing of the […]

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