In this article, I will show you how to accurately estimate terminal value, which is a figure you'll need to calculate when using the discounted cash flow (DCF) model to value businesses. I'm also going to discuss three ways of calculating the terminal value, in regards to companies on the stock market, and which method to use depending on the investment. This will give you the ability to apply absolute valuation methods to companies more effectively.
Terminal Value Definitions and Concepts
Before discussing these three methods of calculating terminal value, you must understand the definitions of the "forecast growth period" and the concept of the "time value of money."
The forecast growth period refers to the period of growing future cash flows that a business may produce (usually over 5 or 10 years). These future cash flows (over the forecast growth period) are discounted back at an appropriate rate, such as the WACC, our personal required rate of return, or the risk-free rate.
Future cash flows are discounted due to the time value of money (TVM), which states that a dollar today is worth more than a dollar in the future due to its potential earning capacity. Therefore, any money that you project into the future needs to be discounted back to the present day or your valuation range will be misleading.
Terminal value (TV) is the value of a business beyond the forecast growth period for when future cash flows can be estimated, as you cannot estimate cash flows forever. By finding the terminal value, investors can estimate what the cash flows will be after the forecast growth period.
Now, the next few sections will cover the three main methods I use to calculate terminal value, and when it would make sense to use one over the other.
Method #1: Exit Multiple Method
The most common way investors estimate terminal value when analyzing companies is with the exit multiple method, which is favored by investment bankers as well. This method works better in cases where you are more certain that a company will not be operational or as-profitable by the end of the forecast growth period (i.e., after 10 years). So, it's the better choice for less predictable companies as well.
With the exit multiple method, you'll estimate future growth for 5 or 10 years, for example, and then factor in a multiple to the earnings figure (usually EBIT or EBITDA) in the last forecast growth year. By doing so, you'll assume that the business you're completing a DCF model on will be sold by the end of the forecast growth period.
Below is the traditional exit multiple approach for calculating terminal value:
FV of TV = Financial metric (EBIT or EBITDA) * Trading multiple (i.e., EV/EBITDA)
where:
- FV of TV = future value of terminal value
- EBIT = earnings before interest and taxes
- EBITDA = earnings before interest, taxes, depreciation, and amortization
Deciding on which trading multiple to use can be a more involved process where you have to analyze comparable companies and look at the financial statements to come up with an appropriate multiple to use. However, a frequently used trading multiple here would be EV/EBITDA, also known as the enterprise multiple.
Other multiples that can be used with this approach include:
- Price-to-earnings (P/E) = Stock price / Earnings per share (EPS)
- Market-to-book = Market capitalization / Total book value (total assets - total liabilities)
- Price-to-revenue = Market capitalization / Total revenue
The simpler, but less common approach, is to use the final year's free cash flow number you projected in your DCF calculation, and to use this instead of EBIT or EBITDA:
FV of TV = FCF * Trading multiple (i.e., 10x)
where:
- FV of TV = future value of terminal value
- FCF = Free cash flow for the last 12 months of the forecast growth period
In this case, we're taking the final cash flow (FCF) number generated by the forecast growth period and multiplying it by the 10-times trading multiple, which gives us the future value of terminal value.
I use a 10-times trading multiple, as it assumes that a business will grow their cash flows for 10 years, and by the end of the 10th year, I'll hopefully be able to sell the business for at least 10-times the amount of cash flow than it's producing in that 10th year. So, I would receive a lump-sum by the end of the 10-year period.
Regardless of the approach you take, you need to discount this future value of the terminal value (FV of TV) to account for the TVM:
PV of TV = (FV of TV) / (1 + r)n
where:
- PV of TV = present value of (future) terminal value
- FV of TV = future value of terminal value
- r = discount rate (required rate of return)
So, if we projected our cash flows to the 10th year, we would have to discount this back to the power of 10 (n). This would be discounted at our required rate of return, the WACC, or the risk-free rate (depending on which discount rate you prefer using). This would then give you the actual (present) terminal value number.
Exit Multiple Flaws
There are two flaws with using the exit multiple approach to find terminal value, but the main problem here is that it's dangerous to mix relative and discounted cash flow valuation.
1. Lack of future cash flow analysis
To begin, when you add a multiple to cash flows at the end of a forecast growth period, you've completely eliminated any analysis on the potential future cash flows a business can generate.
Instead, what you're now doing is relative analysis, where you're comparing companies in the same industry and analyzing how the market has priced them. So, if you were to compare a company such as Apple (AAPL), that generally has high earnings growth, to another company with a much lower earnings multiple, you'd be ignoring any cash the business could potentially generate in the future.
2. The 10-times trading multiple figure is arbitrary
The second flaw is that you cannot use a constant trading multiple figure, such as 10, to every company you value. Some businesses may continue to grow over 10 years and others may struggle to grow after the 10-year period. Others may be cyclical companies which a median multiple would fail to account for.
So, to apply a standard 10-times trading multiple to every company you value, assuming that you can sell their company for 10-times their cash flows after the 10th year is rather arbitrary, and clearly not always accurate. Even if you were to look at comparable companies and use the EV/EBITDA approach, this problem would still arise. Because of this, you may notice this method to be more variable than the other two following methods.
Method #2: No-Growth Perpetuity Method
The no-growth perpetuity method assumes that a company no longer grows after the end of your forecast growth period, say 10 years, but continues to produce cash flow into infinity. This method is easier to grasp mathematically, and is what I would recommend using for many large/established companies in the stock market.
In specific, this method may be more applicable in industries where there is high competition and excess returns move towards zero.
Below is the no-growth perpetuity formula to calculate terminal value:
FV of TV = FCFn / r
where:
- FV of TV = future value of terminal value
- FCFn = Free cash flow for the last 12 months of the forecast growth period
- r = discount rate (required rate of return)
Here, we're taking the final year cash flow generated by the business and dividing it by our discount rate. Again, the "r" here would be your required rate of return, the WACC, or the risk-free rate (depending on which discount rate you prefer using).
Again, discounting this back (as with the exit multiple method) will give you the present terminal value number:
PV of TV = (FV of TV) / (1 + r)n
From a conservative value investor perspective, using a perpetuity with no growth makes sense as you're recognizing the company will likely continue to produce cash flow after your forecast growth period. In other words, we do not assume that the company will cease to exist (like the exit multiple approach), which is safe to assume for most companies with an economic moat and strong past performance, among other things.
In short, by being conservative and not assuming any growing cash flows after the forecast growth period, investors may be able to more accurately value companies and protect their downside risk.
Method #3: Perpetuity Growth Method (Gordon Growth Method)
The final method for calculating the terminal value of a stock is to use the perpetuity growth method, also called the Gordon Growth method. As you may have guessed, this is very similar to the no growth perpetuity method above, but instead of assuming that the company no longer grows their cash flows anymore, we're assuming that they continue to grow at a constant rate into perpetuity (forever).
In comparison to the exit multiple method, this method may be the better choice if you have no good comparable companies or if you believe the trading multiple will vary significantly over the years. So, if you're valuing cyclical companies or those with a strong economic moat, this may be the better approach to take. You may also find that you will get higher terminal values when using this approach.
However, this approach is not generally suitable for small to mid-cap companies with uncertain cash flows, or companies that generally cannot be classified as having an indefinite operating life, such as hedge funds.
Below is the perpetuity growth (aka Gordon Growth) method formula for calculating terminal value:
FV of TV = FCFn * (1 + g) / (r - g)
where:
- FCFn = Free cash flow for the last 12 months of the forecast growth period
- r = discount rate (required rate of return)
- g = estimated annual growth rate
Again, you must discount the future value of this terminal value solution to account for the TVM, using the same formula:
PV of TV = (FV of TV) / (1 + r)n
As you can see, the difference here is that we have a terminal growth rate (g), which is the estimated growth rate the company will grow at, forever.
The important thing here is that the growth rate that you're using to project cash flows into infinity forever (g) must be smaller than your discount rate (r). Moreover, if you're using a discount rate for intrinsic value, such as 1.55%, the current risk-free rate, then you cannot use a growth rate that is above this. If you do, you would get a negative terminal value.
Furthermore, when investors use a perpetuity growth formula, they will use a growth rate that is somewhere around inflation, long-term inflation, or long-term GDP growth. So, somewhere around 1-3% is a rough ballpark figure to put into this formula for terminal value growth. Anything beyond this will likely blow out your valuation, which is why some investors also like to keep this growth rate near 0%.
The Bottom Line
In summary, your forecast growth period estimation, typically over 5 or 10 years, will have the biggest impact on the price you're willing to pay for a business. Beyond 10 years, the cash flows a business may generate will not significantly alter your valuation or final buy price, primarily because the cash flows you receive then will be worth so little to you today. In addition, once you get past 5-10 years, it becomes difficult to accurately predict a company's cash flows. We've recently seen this occur with the unforeseen pandemic which has shrunk cash flows for many businesses.
Now, for whichever terminal value calculation approach you use, it's important to use a range of appropriate discount rates, exit multiples, and perpetuity growth rates in order to have the most accurate DCF model. This is because the discount rate and growth rate are assumptions, and over-estimations in one or both can lead to misleading figures.
Personally, when I value businesses, I typically assume that they will continue to produce cash, but not grow this whatsoever. So, I believe that using a perpetuity model with 0-1% growth makes the most sense for long-term value investors who want to be conservative. However, if you're conflicted on what approach to take, you can always use each of the three approaches and then take the average to come up with a final terminal value number, which you can then use in your absolute value calculations.