Terminal Value

Written by Fmi.Online Friday November 11, 2022
Terminal value is the sum of all cash flows from an investment or project beyond a forecast period based on a specified rate of return. In other words, it’s the estimated value of an asset at maturity adjusted for interest rates and cash flows in today’s dollars. This is important for the calculation of the expected future cash flows using the dividend cash flow valuation model.

Explanation :

The TV determines the value of a project at some future date when exact future cash flows cannot be estimated. Although there are various ways to calculate the terminal value, the most popular approach is the Gordon Growth Model. The GGM assumes that a company will continue to generate a stable growth forever and values a project in perpetuity. The model also assumes that the cash flows of the last projected year are stable and discounts them at weighted average cost of capital  to find the present value of the expected future cash flows.   To calculate this ratio using the GGM, we need to know:
  • FCFF = free cash flow in the final year
  • g = perpetuity growth
  • WACC = discount rate
Therefore, the terminal value formula is calculated like this TV = FCFF x ( 1 + g ) / ( WACC – g )

In a nutshell :

  • Terminal value (TV) determines a company's value into perpetuity beyond a set forecast period—usually five years.
  • Analysts use the discounted cash flow model (DCF) to calculate the total value of a business. The forecast period and terminal value are both integral components of DCF.
  • The two most common methods for calculating terminal value are perpetual growth (Gordon Growth Model) and exit multiple.
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