Terminal value is the value of an investment beyond an initial forecast period. Terminal value, also referred to as TV, is often estimated in the discounted cash flow model as a way of accounting for the value of the firm at the end of the forecast investment period or the timespan over which a more precise valuation can be measured.
This article will explain terminal value, how to estimate it, and why an investor might need to consider the terminal value of an investment.
Definition and Examples of Terminal Value
The value of a business or investment is the present value of its expected future cash flows. To determine that value, an investor or analyst will need to estimate those future cash flows because due to our inability to predict the future, they can’t be known with certainty.
Terminal value is the value of an investment at the end of an initial forecast period.
This is an important concept for anyone who conducts discounted cash-flow analysis because although an investor may feel confident projecting expected cash flows for several years into the future, the further off projections are, the less inherently accurate they become.
This isn’t unique to finance. For an easy-to-follow example, consider a weather forecast. A rain forecast three days in the future is usually pretty reliable. Forecasting rain three months into the future is much less so.
Because the value of an investment is the present value of all expected future cash flows, this inability to know those future values needs to be addressed.
As an investor who analyzes fundamentals, you can account for this gap by first estimating a value over the time period for which you are confident in your ability to accurately assess cash flows, then use a more generalized approach to estimate the remaining, or terminal, value.
The first step in this process would be to estimate the value of an investment for the chosen period using a valuation technique such as the discounted cash flow model. The next step would be to estimate the terminal value at the end of that period.
The total value of the investment is the combined value of those two estimations.
How Do You Calculate Terminal Value?
There are three primary ways to estimate terminal value: liquidation value, the multiple approach, and the stable growth model.
Liquidation value assumes the company will not continue operations forever, but will be closed and sold at some point in the future, and the estimated net sale value will become the terminal value. There are two ways to estimate the liquidation value. Both methods focus on the company's assets.
The first method is to assume the assets can be sold for their inflation-adjusted book value. The second assumes the assets still have the ability to generate a certain amount of cash flow that is then discounted to the present value at the time of the liquidation.
Here is an example using the first liquidation-value approach. Assume the book value of the firm's assets is expected to be $1 billion at the time of liquidation. Further assume that inflation is expected to be 2% and the average age of the firm's assets will be eight years.
The formula looks like this:
Expected liquidation value = book value of assets in the terminal year (1+ inflation rate)Average life of assets
Using the formula above applied to our example:
The expected liquidation value is $1,000,000,000(1.02)8 = $1,171,659,381
For an example of the second approach, assume that the assets are expected to generate cash flows of $250,000,000 per year for 10 years after the terminal year and that the firm has a 8.5% cost of capital.
The liquidation-value formula and amount in this case would look like this: = $1,640,337,015
The terminal value as calculated by the multiple approach is based on an assumption that the business could be sold for a multiple of some chosen fundamental measure of value such as revenue or net income, one that’s observable for comparable businesses.
The multiple approach is simpler to calculate than the other methods. You simply multiply the chosen financial metric by the valuation multiple.
A formula for it would look like this:
TV = Financial Metric (e.g., EBITDA) x Trading Multiple (e.g., 10x)
In investing, the multiple approach is a relative valuation measure, meaning the multiple is usually chosen by seeing what other companies are trading for in the current market. So if an investor sees that comparable companies are currently trading at around four times revenue, then a multiple of four may be selected.
The stable-growth model assumes the business continues to operate and generate cash flow that grows at a constant rate beyond the investment period and is reinvested. The terminal value in the stable-growth model is the value of those estimated cash flows discounted back to the end of the initial investment period.
In other words, suppose you had initially forecast an investment five years into the future, at which point you need to estimate the terminal value. You would discount the estimated cash flow beyond that fifth year back to the end of the fifth year.
Here’s an example of how the stable-growth model would be used to calculate the terminal value of an investment. Assume the same $250,000,000 in expected cash flows and 8.5% cost of capital as above, but now include an assumption that the cash flow could grow at 5% per year.
Terminal value = Cash flow in the next period/(Discount Rate - Stable Growth Rate)
The discount rate is either the cost of capital, if you’re calculating the terminal value of the firm or the cost of equity if you’re calculating the terminal value of equity.
Using the formula above in our example:
The value of cash flow in the next period would be $250,000,000 x growth rate divided by cost of capital minus growth rate:
Terminal Value = $7,500,000,000
How Terminal Value Works
Terminal value is important in corporate finance for valuing companies in mergers and acquisitions (M&A) and for some analysts who work for investment firms. Some individual investors may incorporate terminal value into their analysis, but not all, because not every investment strategy requires you know or understand the concept.
For example, this information does little for a passive index investor because that style of investing doesn’t rely on individual investment valuations. Mutual fund investors do not need to think about terminal value because even if the fund’s strategy involves the use of terminal value, there are analysts and fund managers handling that for you.
What It Means for Individual Investors
If your investment strategy relies on discounted cash flow valuation, then you need to understand and incorporate terminal value into your investment valuation process.
The estimation of terminal value is helpful to individual investors who choose to invest based on fundamental analysis because it provides a way of estimating the value of an investment beyond the period for which they believe they can obtain a valid forecast.
- Terminal value is the remaining value of an investment beyond a forecast period.
- There are three ways to estimate terminal value: liquidation value, multiple approach, and stable growth.
- Calculating terminal value is important in corporate finance and some investment strategies.
- Not all investors need to assess terminal value.