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Terminal Value (TV) is an invaluable tool used by analysts to ascertain the total value of a business. When calculating the value of a company, analysts generally use a Discounted Cash Flow (DCF) method within a defined period, typically three to five years. To include the value of the business beyond this forecasted period, analysts utilize TV to account for the expected future cash flows of the business.
The two most popular ways to calculate TV are the perpetual growth model (Gordon Growth Model) and the Exit Multiple method. The perpetual growth model assumes that the business in question will indefinitely generate future cash flows at a constant rate, while the Exit Multiple model estimates the price of what a company would be sold for.
The Gordon Growth Model is a modified form of dividend discount model, which assumes that all future free cash flows are reinvested at a certain rate, thus influencing the amount of future cash flows. The only input into this calculation is the perpetuity growth rate, which assumes that the growth rate will remain constant through eternity. As this calculation requires very little variables, it is a relatively straightforward.
The Exit Multiple model is more complicated than the Gordon Growth Model but more accurate when calculating TV. This method refers to the total sum value of a business, divided by its expected cash flows in the terminal year. This figure, along with an estimate of future years’ cash flows, gives an accurate estimate of the value of the business in perpetuity, beyond the forecast period.
Overall, TV is an essential part of determining the total value of a company. It helps amalgamate the expected future cash flows into one total figure. Calculating TV accurately is difficult, which is why analysts must carefully consider which method is most applicable.
The two most popular ways to calculate TV are the perpetual growth model (Gordon Growth Model) and the Exit Multiple method. The perpetual growth model assumes that the business in question will indefinitely generate future cash flows at a constant rate, while the Exit Multiple model estimates the price of what a company would be sold for.
The Gordon Growth Model is a modified form of dividend discount model, which assumes that all future free cash flows are reinvested at a certain rate, thus influencing the amount of future cash flows. The only input into this calculation is the perpetuity growth rate, which assumes that the growth rate will remain constant through eternity. As this calculation requires very little variables, it is a relatively straightforward.
The Exit Multiple model is more complicated than the Gordon Growth Model but more accurate when calculating TV. This method refers to the total sum value of a business, divided by its expected cash flows in the terminal year. This figure, along with an estimate of future years’ cash flows, gives an accurate estimate of the value of the business in perpetuity, beyond the forecast period.
Overall, TV is an essential part of determining the total value of a company. It helps amalgamate the expected future cash flows into one total figure. Calculating TV accurately is difficult, which is why analysts must carefully consider which method is most applicable.