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Terminal Value

 

Terminal value is a value of the business (or other asset) used in discounted cash flow (DCF) method that is added after the discontinuing of the cash flow forecasting.

 

DCF valuation is based on the sum of free cash flow which is discounted to the current value. If we could predict the cash flow of the future forever, then we won’t be needed for terminal value but the problem is that most of the times it is very hard to predict the cash flow for a longer period than five years. However, when forecasting period stops, the residual assets (basically business) are still valuable and that value is equal to terminal value.

 

Terminal value calculation

 

In financial practice few methods are used to determine terminal value:

 

1. Perpetuity value model is the most popular method among analysts and the most appropriate when a stable cash flow can be predicted. 

 

Terminal value = Cash flow of the perpetual year / (Discount rate – Growth rate)

 

Cash flow of perpetual year is the free cash flow that can be generated by asset. In case of business valuation cash flow is equal to previous year cash flow plus annual growth. However, in most cases previous free cash flow should be also adjusted according to working capital changes and investments in assets while these numbers for previous year and for terminal year usually are different. The influence of working capital changes and capex for terminal year cash flow should depend on terminal Growth rate.

 

Growth rate should be some percentage that represents the perpetual growth over very long period. Depending on the business sector this growth can be 1%-4% under normal inflation conditions. 

 

Discount rate can be determined by several methods but WACC (weighted average capital cost) is the most appropriate one. 

 

2. Relative valuation is based on valuation multiples as EV/S, EV/EBITDA, P/Bv or others. Basically terminal value is calculated in the same way as current value is calculated using relative valuation. However, historical approach for average industry ratios can be used as well. 

 

3. Asset sale value method also can be used for terminal value determination. The previous two methods are more popular, but sometimes, when the object is very liquid or should turn in to liquid one in the future, his book value can be used. 

 

 






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