What is Terminal Value (TV)?
Terminal Value Definition
Terminal value, or TV for short, is the expected value of a business or project beyond the forecast period–usually five years.
Since forecasting gets hazy as the time horizon increases, forecasting a company’s cash flow or the value of a project becomes more difficult.
Instead of attempting to wade into the unknown, analysts use financial models like Discounted Cash Flow (DCF) along with some baseline assumptions to ascertain Terminal Value.
How to Calculate Terminal Value
Two of the most commonly used methods to calculate terminal value are the Perpetual Growth Model (Gordon Growth Model), which assumes a business or project will last into perpetuity, and the “Exit Approach,” which assumes an end date to said business or project.
The TV of a business or asset includes the value of all future cash flows, even those not part of the projection period, in an attempt to capture values that are typically difficult to predict in regular financial models.
TV takes into account all possible changes in value expected to occur before the maturity date, such as interest rates, and it assumes a steady growth rate.
However, due to the Time Value of Money, the TV must be translated into the present value in order to mean anything.
The formula for Terminal Value is as follows:
FCFF x ( 1 + g ) / ( WACC – g ) = TV
Terminal Value Example
For example, John is a financial analyst and is asked to determine the TV of a project expected to grow perpetually by 2% annually.
John estimates that the FCF (Free Cash Flow) in year six will be $22 million and calculates a discount rate of 12%.
Using the information provided and the formula above, the equation for John would be as follows:
$22 x ( 1 + 0.02 ) / ( 0.12 – 0.02 ) = $22 x 1.02 / 0.1 = $224.4 million.
So, John calculates that the TV of the project is worth $224.4M today.