Terminal Value (TV) is a significant metric used by investors and finance professionals to determine the long-term value of a company. The Terminal Growth Rate is the estimated pace at which a company is expected to grow beyond the forecast period.

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The Terminal Value explained.

In valuation theory, a company’s value equals all future free cash flows derived from that business. Cash Flows are discounted to the present value at a Discount Rate representing the Weighted Average Cost of Capital. The DCF (Discounted Cash Flow) model consists of two components: the Forecasted period and the Terminal Value.

When using the DCF model, analysts and investors forecast 5 or 10 years of earnings and cash flow by modelling the financials. It becomes increasingly difficult to model beyond this into perpetuity. Therefore, we must find the Terminal Growth Rate that can extrapolate our model at a steady rate to help determine an overall Terminal Value.

When projecting a company’s free cash flow, it is best to assume there will be different growth rates based on the stage of the business cycle. For example, a hyper-growth company may show signs of strong 15% growth in the first 5-to-10-year model. However, as it gains market share, starts to mature and enters a new cycle, the growth tapers off. We need to model this (with caution) into the future.

The terminal value can make up the largest component of the valuation for a company, especially if the forecast period is smaller. For this reason, the Terminal Growth Rate needs to be conservative and well-thought-out. If the Terminal Value does make up the bulk of your valuation, slight 1% changes can have drastic effects on the present value outcome.

To calculate intrinsic value, you need to consider both the terminal value and the value of the business up until that point, then discount it back to the present using the appropriate discount rate.

What is the Terminal Value formula?

There are two common methods for calculating the terminal value. The first is the perpetual growth method which is based on the idea that the company may generate free cash flow at a constant rate into the future. The second is the exit multiple method which assumes that the company may sell in the future.

It’s a good idea to use both the perpetual growth method and multiples method together to determine if your valuation is accurate. The Growth Rate input is very sensitive, which is why it’s important to compare the end valuation against multiples. This will give you a better perspective on the numbers. Sometimes, we may think that the perpetual growth method provides an accurate valuation, but then we compare it to a multiple like the P/E and realise that it’s either unrealistically undervalued or overvalued.

Perpetuity Growth Method

The Terminal Growth Rate relies on the assumption that the business will continue to produce consistent and sustainable growth beyond the last forecasted period. This is a big “IF”, if the business maintains its competitive edge, has no lumpy years in earnings and that market conditions remain very stable.

When using the perpetuity growth method, the TV is calculated by treating a company’s terminal year (the last FCF Year in our projection, hence “terminal” year) as a growing perpetuity at a fixed rate once the company has stabilised.

• TV = (FCF X (1 + g)) ÷ (WACC – G)
• FCF = Free Cash Flow
• g = Perpetual Growth Rate
• WACC = Weighted Average Cost of Capital

Free Cash Flow = Calculated by deducting capital expenditures from the operating cash flow. It is the cash flow that is “free” to be used to pay back to shareholders or retain.

Growth Rate = The Terminal Value is calculated by applying a constant annual growth rate to the cash flow of the forecast period. The perpetuity growth rate is how much the free cash flow of the company grows forever. A lot of investors and analysts use a growth rate such as GDP or CPI to keep up with inflation.

Weighted Average Cost of Capital = The WACC is the total cost of Capital from both sources, Equity and Debt. The Capital Asset Pricing Model is used to calculate the cost of Equity and then added to the Cost of Debt. The WACC is often used as the discount rate in a DCF as that is the expected return investors seek. The discount rate takes into account the time value of money and helps to determine a present value of the future cash flows.

Exit Multiple Method

The exit multiple method works around the idea that the business is sold for a multiple of some financial metric such as EBITDA. This method is often used in conjunction with the perpetual growth rate to cross check the Terminal Value from the DCF.

• EM = Financial Metric x Trading Multiple
• Financial Metric = Can be EBITDA or Price-to-Sales depending on what investors use.
• Trading Multiple = This is the Multiple that is used from the Ratio the investor chooses.

A lot of investors and analysts use either the EV/EBITDA, the Price-to-Sales or the Price-to-Earnings multiples. Then take the last forecasted year of Free Cash Flow and multiply it by the multiple giving the Terminal Value. That Terminal value is then discounted by the discount rate assumption back to todays present value.

Using the Perpetual Growth Method in the DCF.

Let’s dive straight into an example using the Perpetual Growth method to determine our Terminal Value and see how this translates into under or over valuation.

We want to value Company A and see if the current share price is reasonable to invest. We will work on a smaller 5 Year forecasted cash flow projection then determine our Terminal Value. Assuming the following numbers.

• 5 Year Projected Forecast Period
• TTM (Trailing Twelve Months) FCF = $125m
• Long-Term Growth Rate = 11%
• WACC used as our Discount Rate = 6.2%
• Perpetual Growth Rate = 2.5%
• Oustanding Shares = 45 million
• Current Share Price = $92.50

Step One is determining the Projected Free Cash Flow for the 5 years.

DCF	Year 1	Year 2	Year 3	Year 4	Year 5
Projected Free Cash Flow	$138.75m	$154.01m	$170.95m	$189.76m	$210.63m
Discount Factor *WACC	0.941	0.886	0.834	0.786	0.74
Discounted Free Cash Flow	$130.56m	$136.46m	$142.58m	$149.15m	$155.87m

Net Present Value = Y1 + Y1 + Y3 + Y4 + Y5 = $714.61 Million.

So as a short recap, we simply take the TTM Free Cash Flow, extrapolate that out for the next 5 years by our expected growth rate of 11%. We discount that value back to the present by our discount factor of 6.2% giving us the Discounted Free Cash Flow. We tally those 5 years up to come up with the Net Present Value.

Step Two is determining the Terminal Value.

We need to use the same numbers and growth rate but this time taking the last projected Free Cash Flow year which is $210.63m in Year 5. We know the perpetuity growth rate is 2.5% and our discount factor is 6.2%. Let’s throw it all together. The Discount Factor is the multiple in Year 5 of our DCF model above which is 0.74.

Terminal Value = 210.63 x (1 + 0.025) ÷ (0.062 – 0.025) x 0.74 = $4.31 billion

*We can do this in two parts, we can calculate the Terminal Value first and then discount it by the Year 5 discount factor or simply throw it all in one formula which I have done above.

The final step is adding our NPV to the TV and then calculating Enterprise Value.

Now that we have the 2 sets of numbers we add them together to get our Enterprise Value or Intrinsic value after making alterations for cash and debt.

Net Present Value + Terminal Value

$714.61 Million + $4.31 Billion = $5.03 Billion

The Intrinsic Value of Company A is $5.03 Billion. Now the final stages in the DCF using this Perpetual Growth method is after making our adjustments we divide the Enterprise Value by the total number of shares giving us our indicative share price.

DCF Valuation
Enterprise Value (NPV + TV)	$5.03 Billion
+ Add Cash	$52.5 Million
– Minus Debt	– $108 Million
Equity Value of Company	$4.97 Billion
Outstanding Shares	45 million
Valuation Per Share	$110
Current Share Price	$92.50
Undervalued	18.91%

And voila, we have conducted a very simple DCF model using the Perpetual Growth Rate method to determine the Terminal Value. Whilst this is a simple example, it does get more complex as modelling can be quite lumpy. I use excel for all working calculations and DCF modelling to help calculate various assumptions. I typically run 3 scenarios showing a higher and lower discount rate and perpetual growth rate to show how far apart the final valuation can be.

Using the Exit Multiple Method to determine Terminal Value.

Let’s build on the valuation of Company A now that we have completed a simple Terminal Value calculation using the Terminal Growth Rate method. Let’s use the second method the exit multiple to see how far off we were.

To determine each component, we are taking the numbers we have used in our final forecasted year. Once we have the final year forecasted, we can then multiply this number by the multiple of our chosen Investment Ratio. Once we have this Terminal Value, we need to discount that back to the present value and then finally divide it by the shares outstanding to get our “Implied” share price.  

The Exit Multiples is best used in conjunction with comparable public companies’ multiples. This provides a very realistic approach to the valuation based on the industry landscape.

Stages to determining Enterprise Value by exit multiples

• Comps-Based multiple = Let’s use the EBITDA multiple in this example. The comps based multiple is derived from other competitors and the industry average EV/EBITDA multiple.
• Determine the Final Year EBITDA on the projected modelling of the financials.
• Multiply the final year (Terminal) EBITDA by the EV/EBITDA multiple.
• This determines the Terminal Value based on the EBITDA multiple.
• We then discount this Terminal Value back to the present using our Discount Rate (WACC).
• Once we have the discounted present terminal value we add it to the Present Value Free Cash Flow we modelled out.
• After alterations for cash and debt we have the equity component which can then be divided by the shares outstanding giving us the share price valuation.

Using Company A and the details from our previous example let’s build on top of this by assuming the industry average has an EBITDA Multiple of 9.2x.

EBITDA Multiples Approach
EV/EBITDA Multiple	9.2x
Terminal Year EBITDA	$586.5 Million
Terminal Value in Year 5	$5.39 Billion
Present Value of Terminal Value	$3.98 Billion
Present Value of Projected Free Cash Flow	$714.61 Million
Implied Growth Rate	2.20%
Enterprise Value	$4.7 Billion
+ Add Cash	$52.5 Million
– Minus Debt	– $108 Million
Equity Value of Company	$4.64 Billion
Outstanding Shares	45 Million
Valuation Per Share	$103.11
Current Share Price	$92.5
Undervalued	11.40%

So, in this Exit Multiples analysis we have reverse engineered in a way the numbers and they are not so far off our Perpetual Growth Rate model. The difference is 0.3% in the growth rate which is still within a reasonable number. If this implied growth rate spits out a number with a large discrepancy it forces you to rethink the numbers, the forecasted period, and the implied growth rate.

Full working calculations for the Exit Multiple Method:

To show how each stage was calculated I will break it down showing working calculations. I tend to learn better seeing how the numbers interact.

EBITDA Multiple = 9.2x Taken as the average from the industry and comparable competitors.

Terminal Year EBITDA = $586.5 Million Calculated by forecasting the TTM EBITDA to the Year 5 period.

Terminal Value in Year 5 = $586.5 Million x 9.2 = $5.39 Billion (EBITDA x Multiple)

Present Value of Terminal Value = Using the Discount Factor formula it is Terminal Value ÷ (1+WACC)^(Years forcasting) thus $5.39 Billion ÷ (1+6.2%)^(5) = $3.98 Billion

Enterprise Value = Net Present Value of forecasted Free Cash Flow from Stage one of our model + Discounted Terminal Value. $714.61 Million + $3.98 Billion = $4.7 Billion

Equity Value of Company = Enterprise Value adding cash and minus debt so $4.64b + $52.5m Cash – $108m Debt = $4.64 Billion

Valuation Per Share = Divide the Equity Value by Oustanding shares. $4.64b ÷ 45m Shares = $103.11

Under or Over valued = Take the implied share price and minus the current share price. Take the difference and divide it by the current share price to give you a %.

That shows how each of the numbers have interacted to find our valuation.

What is the Implied Terminal Growth Rate calculation?

The implied terminal FCF growth rate is a reverse calculation when you have all the other inputs. When we approach the Terminal Value with the assumed growth rate, we can then test our theory out by reverse engineering the growth rate with the Multiples method. It can help to see how accurate our initial share price valuation was.

• Implied Growth Rate = Terminal Value x Discount Rate (WACC) – Final Year FCF) ÷ (Terminal Rate + Final Year FCF)
• Multiply the decimal by 100 to get the %.

Working on for the Exit Multiple calculation for Company A let’s use the above formula to calculate the Implied Terminal Growth Rate. The final year Free Cash Flow (Terminal FCF) is found in the first part of the Projected Free Cash Flow for the 5 years when working out the perpetual growth rate.

($5.39 Billion x 6.2% – $210.63 Million) ÷ ($5.39 Billion + $210.63 Million) x 100 = 2.2%

As another safety measure if the implied growth rate seems excessive you can work out an estimated exit multiple by using the following formula. This helps to use the numbers you have to see if the multiple aligns with the industry or comparable companies.

Implied Exit Multiple = Unadjusted Terminal Value ÷ Final Year EBITDA

What are the downsides of using the Terminal Value?

Determining the Terminal Value is important, but getting the Terminal Growth Rate right is critical. This is because even slight micro changes or 1% variances in the growth rate can present vastly different values when modeling something into perpetuity. Hence, every small change in the growth rate will create a large disparity in the Terminal Value which ultimately affects the final share price valuation.

For example, a 2%, 4% and 6% Terminal Growth Rate will create huge differences in the present value calculations. However, the perpetuity growth model is limited by the difficulty of predicting an accurate growth rate. Furthermore, any assumed value in the equation can lead to inaccuracies in the calculated terminal value.

The exit multiple method is also limited by the nature of multiples, as they change as time passes or as the company goes through various stages of the business cycle. For instance, if using revenue or earnings multiples, a hyper-growth company becomes hard to find a terminal value because the multiple may be wildly different in a couple of years.

In Summary…

There are several methods to estimate the Terminal Growth Rate, including using industry averages, historical growth projections, and economic forecasts. Regardless of the method used, it is essential to use very conservative assumptions to avoid overestimating the company’s future growth and thus the share price.

It is advisable to run a sensitivity analysis that expresses the impact of growth rate changes on valuation, as well as other factors such as how the multiple can change. It’s better to be generally correct while conservatively extrapolating these numbers, rather than absolutely wrong. I think it’s important not to forecast aggressive rates of growth and then shrink it with a tiny perpetual growth rate. This creates a lot of problems, especially if the Terminal Value makes up a large (more than 50%) part of the Enterprise Value.

In theory, the exit multiple is a useful point of reference for the potential future valuation of the target company once its growth has stabilized. I like to use multiples in the micro-cap and small-cap space as many mergers and acquisitions by investment banks use the same concepts of EV/EBITDA. The Enterprise Value is a very good way to value these smaller companies.

There are many more reference points for what take-overs have traded for, so I find running actual numbers based on comparable case studies a lot more accurate than guessing growth.