Business forecasts always have some level of uncertainty. But, the longer the time horizon, the more speculative a forecast becomes.
In other words, teams will typically have a higher confidence level in forecasting a business’s cash flows for the following month rather than 25 years into the future.
This poses a challenge when performing a business valuation. Whether leadership is pricing the company for a potential acquisition or investors are performing a stock market valuation, determining the long-term value of a business in present-day values is of key interest to stakeholders.
This is where the concept of terminal value comes into play. So, what is terminal value, how is it calculated, and how is it used for business valuations? This article will address each of these questions and more below.
What is terminal value (TV)?
Terminal value represents the estimated value of a business after the initial forecast period.
It helps investors and business leaders determine how much the company will be worth in the long term, which can drive important decision-making.
While the terminal value can be calculated and assessed on its own, it’s commonly used as an input for a discounted cash flow (DCF) analysis.
Because the purpose of the terminal value is to capture a business’s value after the near-term forecast period, its calculation is based heavily on several assumptions, which can impact its accuracy.
In other words, the TV should not be seen as a perfect estimate of the business's value, as it can vary significantly from actual performance based on macroeconomic factors like inflation, interest rates, and more.
Types of terminal value
Businesses can typically calculate the terminal value in one of two ways:
- Exit multiple
- Perpetual growth/Gordon Growth Model
These two approaches are fundamentally different, meaning they will not yield the same terminal value. So, they are typically seen as two separate TV types.
The exit multiple model relies on the understanding that the business will eventually be sold.
In contrast, the Gordon Growth Model assumes the business will continue generating the same level of cash flows forever. It is often seen as the more optimistic approach between the two, leading to a higher TV.
Thus, businesses and investors may decide to calculate the TV both ways and then average the two values to get a more accurate estimate.
Terminal value formula
The terminal value formula will depend on the specific approach a person is using – the Gordon Growth Model or the exit multiplier model.
Gordon Growth Model approach
Using the perpetuity method, the formula is as follows:
*Free cash flow: For the final forecast period
In this case, the terminal value is found by discounting a business’s free cash flow from the last forecast period by the difference in the discount rate and terminal growth rate.
Its free cash flow can be estimated with a certain degree of confidence up to a certain point in the future. But, the forecasts become less certain further out in the timeline.
Thus, modelers make the assumption that the free cash flow forecast for the final period will continue to grow at a stable rate into perpetuity, hence the name of the model.
Exit multiple approach
For the exit multiple approach, here is the TV formula:
Similar to the previous model, this approach relies on the final EBITDA value in the projection period.
But, in contrast to the Gordon Growth Model, this approach anticipates that the business will cease operations at a certain point, typically when a larger organization acquires it.
Thus, this EBITDA value is multiplied by an exit ratio that’s determined based on the exit multiples of similar, recently acquired businesses.
For example, according to data from NYU Stern, the exit multiple for general retail businesses is 16.63, but 8.97 for farming and agricultural operations.
Therefore, when using the exit multiple approach, a business’s terminal value is based on its projected financial performance and specific industry.
Why is terminal value important for a business to know?
Businesses that are publicly traded or looking for a potential acquisition will be interested in their TV to fully capture the value of its long-term operations, even after the near-term forecast period ends.
So, if a company isn’t in either of these scenarios, why should it be concerned about its terminal value?
Calculating the TV can be important for SMBs for several reasons. For one, it can provide strategic insights to drive financial planning and investment-related decisions.
A business owner may still be curious about its TV to understand its long-term growth prospects and whether its current operations could sustainably support this value for years to come.
Or, they might want to determine whether a significant capital investment, like purchasing a new building or expanding into a new market, could generate a return.
It can also be useful for a business to compare its terminal value to others in the industry, working as a benchmark to help determine its competitive positioning.
Potential limitations of terminal value
Terminal value is a common input in financial modeling. However, it’s not without some flaws. Here are some of the potential limitations and drawbacks of TV:
Reliance on assumptions
The main limitation of the terminal value is that it is heavily dependent on several assumptions, such as the perpetual growth rate or the exit multiple, depending on the model used.
Either way, modelers must carefully choose these input values to produce a TV that’s as accurate as possible.
If they choose values that are too optimistic, it could inflate the company’s value and lead to unrealistic expectations about what it’s worth. On the other hand, values that are too conservative could devalue the company.
Highly influential in valuations
Another common concern is that the terminal value makes up a disproportionate amount of a company’s valuation.
The TV represents the value of the business’s cash flows after the forecast period, which may only be a few years. Thus, it might make up 50% or more of the valuation, depending on how long the company remains in business.
This further underscores the importance of using accurate assumptions in the TV calculation, which is much easier said than done.
Lack of flexibility
Both methods for calculating the terminal value rely on rigid assumptions. They don’t provide room for market downturns, emerging competition, or other factors that impact a business’s cash flows over the long term.
This lack of flexibility doesn’t reflect real market conditions. Thus, it’s unlikely that either model will produce a TV that accurately reflects the business’s true value.
However, such variability is difficult to predict. So, even though the TV calculations simplify real-world market conditions, it still allows businesses to value their operations.
Ability to be manipulated
Because the terminal value formulas depend on several assumptions, there is room for human bias in the calculations.
Internal and external stakeholders might have different motives for doing so, though they can use the various inputs as levers to produce a TV that is ideal for their circumstances.
For instance, a company interested in acquiring another business may opt for more conservative values to produce a lower TV, justifying a lower offer or purchase price. The business’s internal team might do the opposite.
This isn’t to say that all parties are trying to be manipulative. However, it’s important to understand the potential variation in TV calculations and how widely they may vary depending on the specific inputs chosen.
Terminal value vs NPV
After reviewing the formula and use for terminal value, businesses might confuse it with a similar term, net present value.
To clarify, these are two distinctly different financial concepts. As a reminder, the net present value helps businesses determine the profitability of a given project or investment.
It considers the future cash flows the project will produce and applies the discount rate to consider the time value of money.
Oftentimes, businesses will assess the NPV of various projects to determine which projects are feasible and which would produce the greatest profits.
Gain more visibility into your business’s finances
Terminal value can be a tricky concept to grasp if you’ve never thought about the business valuation of your company.
However, it is critical to understand what the TV can tell you about your business and how it might impact your potential valuation down the road.
In the meantime, using an integrated platform for accounts payable, accounts receivable, spend and expense management, like BILL, can help streamline your financial workflows.
The platform allows you to leverage automation and powerful insights to improve operational efficiency and enhance visibility into financial performance.
Sign up for BILL today and see how our integrated platform can help you simplify financial management from one centralized platform.
