Terminal Value

Assuming all else being equal, companies are a going concern. This means that they will continue to operate and generate cash flows even beyond the forecast period i.e till infinity. But it’s not practically possible to build cash flows till infinity. So how is the value of cash flows beyond the forecast period captured? This value is captured by what is known as terminal value. There are two ways of calculating terminal value.

One is the Gordon growth method which assumes that cash flows grow into perpetuity at constant rate g as the company is in a steady state

  • Terminal value is calculated as a multiplication of FCFF in the terminal year by 1 plus g and dividing this by the difference between WACC and g

Terminal Value = FCFF * (1+g) / (WACC - g)

The other method of calculating terminal value is the exit multiple method

  • Here terminal value is calculated by simply multiplying an EBITDA multiple with EBITDA in the terminal year
  • This multiple can be used from either trading or transaction comps
  • If a company is being valued on a stand alone or going concern basis then exit multiples should be based on

trading comps. If on the other hand the assumption is that the business is going to be sold at the end of the forecast period, then it makes sense to use transaction comps as exit multiples