Terminal value

What it means

Terminal value is the value of all of a company's future cash flows beyond the detailed forecast period in a DCF valuation. Since a company usually keeps operating after the five or ten years of the forecast, its value beyond that horizon has to be captured in a single number.

It is most often calculated with a perpetual growth model, which assumes cash flows will grow at a steady rate, or with a multiple such as EV/EBITDA, which reflects what comparable companies sell for in the market. The result is then discounted to present value.

Terminal value often makes up most of the final valuation, sometimes more than two thirds. Small changes in assumptions, such as the growth rate or the discount rate, therefore move the overall enterprise value considerably.

How it works in practice

In the perpetual growth model the growth rate should not exceed long-term economic growth, otherwise the company would in theory eventually outgrow the whole economy. It must also be lower than the discount rate, usually the WACC, or the formula breaks down.

It is useful to calculate terminal value both ways and compare them. If the growth model implies a multiple far above the market multiples of comparable companies, the assumptions are probably too optimistic and should be revisited.

In a business valuation it is advisable to show how sensitive the result is to key assumptions, for example in a table with different growth and discount rates. Scenario analysis shows the range in which the value moves and helps in price negotiations.

What to watch out for

The final forecast year from which terminal value is derived should represent a normalised, sustainable state. If it contains one-off profit, low investment or an unsustainable margin, the error is multiplied into the entire terminal value.

A valuation in which terminal value makes up almost the entire result is very sensitive to assumptions about the distant future. Buyers and sellers alike should therefore check whether the growth and profitability assumptions beyond the forecast period are realistic.