The terminal value (TV) captures the value of a business beyond the projection period in a DCF analysis, and is the present value of all subsequent cash flows. Depending on the circumstance, the terminal value can constitute approximately 75% of the value in a 5-year DCF and 50% of the value in a 10-year DCF. As a result, great attention must be paid to terminal value assumptions. The terminal value may be calculated using two different methods.
Terminal Multiple Method
The terminal multiple method inherently assumes that the business will be valued at the end of the projection period, based on public markets valuations. The terminal value is typically calculated by applying an appropriate multiple (EV/EBITDA, EV/EBIT, etc.) to the relevant statistic projected for the last projected year.
|LTM Terminal Multiple
|Statistic projected for the last 12 months of the projection period
Since the DCF values cash flow available to all providers of capital, EV multiples are generally used rather than equity value multiples. The exit multiple assumption is usually developed based on selected companies’ trading multiples. In certain cases, precedent transaction multiples may be used, depending on the exit contemplated and specific circumstances. Assuming the terminal multiple is being applied to the statistic projected for the last projection year, be sure to use a trailing multiple rather than a forward multiple.
Perpetuity Growth Method
The perpetuity growth method assumes that the company will continue its historic business and generate FCFs at a steady state forever. The TV under this method can be calculated as follows:
|FCFn × (1+g)
|WACC − g
|FCF for the last 12 months of the projection period
|Perpetuity growth rate (at which FCFs are expected to grow forever)
|Weighted-average cost of capital
The perpetuity growth rate is typically between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%. If you assume a perpetuity growth rate in excess of 5%, you are basically saying that you expect the company’s growth to outpace the economy’s growth forever.
The perpetuity growth method is not used as frequently in practice due to the difficulty in estimating the perpetuity growth rate and determining when the company achieves steady-state. However, the perpetuity growth rate implied using the terminal multiple method should always be calculated to check the validity of the terminal mutiple assumption.
Checking Your Work
While the TV may be calculated using either one of these methods, it is extremely important to cross-check the resulting valuation using the other method. For this purpose, it is important to calculate the perpetuity growth rate implied by the terminal value calculated using the terminal multiple method, or calculate the terminal multiple implied by the terminal value calculated using the perpetuity growth method.
For example, the perpetuity growth rate implied by a terminal EBITDA-based TV may be calculated by using the formula:
|TV × WACC − FCFn
|TV + FCFn
Likewise, a multiple implied (e.g. EBITDA) by the TV calculated using the perpetual growth method can be calculated as follows:
|Implied terminal EBITDA multiple