The terminal value can best be understood as the expected sales price of your company at the end of the fast growth period. It is either calculated with a perpetuity formula based on a steady growth rate or by applying an EBITDA multiple.
As you may recall from our DCF section, financial modelling works by predicting your company’s cash flows. The first few years you plan out in great detail and afterwards…well you can’t really predict a company’s future for the next 10 years, let alone a 100 years. No matter how detailed-minded you are, you need to make an assumption for what comes after the first 3-5 years. That is where the Terminal Value (TV) comes into play. As mentioned, it is the value of your company after the end of your financial model.
There are two methods to calculate TV:
Most practitioners use the Exit Multiple method (cause its more convincing to the layman). That said, both methods have their merit and the cute thing about having a second method is, you always have a second chance to drive up your valuation.
1.) Gordon Growth Method
For those of you who just want the formula, here it is:
TV = Terminal Value
FCF = Free Cash Flow of the period after which you want to know the exit price
g = Growth rate of free cash flows in the long term future (after the detailed planning phase)
r = Expected Rate of Return (= Discount Rate)
Detailed Explanation for the Nerds
Again, the discounted cash flow method predicts a company’s worth by saying its value is based on how much income it can generate, discounted by the required rate of return. But how to predict cash flows beyond the first few years? In theory, a successful company lives indefinitely after all. Fortunately, in the long run the constant ups and downs of your company’s performance will balance themselves out. So, why not simply apply one constant growth rate and be done with it?
In fact, the longer in the future a cash flow occurs, the less impact it will have on company value. This is because compounding effects have a much smaller impact on today’s company value due to the many periods of discounting. Your long term growth rate will simply not be high enough to outrun your discount rate.
Now you might argue, doesn’t this approach still require an indefinite planning horizon? Not really. The trick is you do not need to predict each individual years’ cash flows as long as you assume that they will grow at a steady rate forever.
For that we simply use the perpetuity formula, which you might know from loan finance. In case you don’t: Perpetuities are for example loans that pay interest steadily forever. Unintuitively, you can price the value of an indefinite loan with a very simple formula. The annuity formula:
Annuity Formula:
TV = Terminal Value
FCF = Free Cash Flow of the period after which you want to know the exit price
r = Expected Rate of Return (= Discount Rate)
Returns in the far distant future, discounted over very long time-periods will gradually approach a maximum return, which, discounted back, results in its finite and easy to determine present value. So you take next period’s return and divide it by its discount factor r.
To cater for constant growth, we extend this formula by a growth factor. For that we simply deduct the growth rate “g” from the discount factor (= required rate of return) “r”.
Annuity Formula with Growing Cash Flows
TV = Terminal Value
FCF = Free Cash Flow of the period after which you want to know the exit price
g = Growth rate of free cash flows in the long term future (after the detailed planning phase)
r = Expected Rate of Return (= Discount Rate)
To apply this formula for determining our terminal value, we simply pick an estimated growth rate, at which we think the company will grow beyond the fast growth rate and then apply it to the very last free cash flow of our rapid growth period to get “next year’s” free cash flow. This is then divided by (r – g) to get the theoretical sales price of the company in the last year of the rapid growth period. This gets us back to the Gordon Growth Model as shown at the beginning of this page:
Gordon Growth Model Formula:
Now we only need to discount it together with the free cash flow of the last rapid growth year.
2.) Exit Multiple Method
This method predicts the exit price through an EBITDA multiple against other companies. As described in greater detail in our multiples section, such companies should be chosen wisely. They should actually be comparable. Just cause you try to start a tech company, it doesn’t make sense to use Facebook as a default multiple.
Secondly, you need to use the right multiple. Also described in our section on multiples, there are two main kinds:
- Revenue multiples
- Cash Flow multiples
As the DCF works with Free CASH FLOWS, of course you can only use CASH FLOW Multiples. That means use an EBITDA multiple.
Which Method to Choose?
As mentioned, most founders and investors will use exit multiples.
That’s because the approach is simply more intuitive. Anybody understands multiples intuitively, while the Gordon Growth Model requires some math. So if you want to pick only one approach use Exit multiples.
But why not use any method you can find and create valuation ranges? E.g. use DCF with Gordon Growth TV AND Exit Multiple TV and then also add general Revenue Multiples etc. Then create one separate valuation slide that you can show investors if they ask you how you came up with your requested valuation. Ideally that slide predicts an average valuation across all methods that is slightly higher than what you ask for. In that sense, Gordon Growth is great cause its input assumptions are so vague you can use it as the high valuation. Afterall, who can really argue that 2% growth is more correct than 3%!?
Final Considerations
Please be careful: It is very easy to confuse the time setting of all of these variables. While you are more or less free to choose what-ever time frame for your rapid growth period (for example 3 to 5 years), you must always calculate the terminal value for the end of the last rapid growth period. And for that you must always grow the free cash flow of that last rapid growth period by one more period. And, of course, you must then discount the terminal value by the right number of periods to get the right present value. In case you are curious, if you would add another period to the rapid growth period during which you let the last rapid growth period grow only by the steady growth rate and push the terminal value calculation one more period into the future, the result would be exactly the same, as starting with the terminal value one period earlier. The reason why we can’t start with the Terminal Value even earlier is because the growth rate of the first few years will be different and likely fluctuating.
Summary:
- Exit Multiple Method is preferred by founders and investors
- Use both methods to have more arguments for your preferred valuation
- In applying Gordon Growth method, watch out for the right periods when discounting (common mistake)
- In applying the Exit Multiple method, be sure to use a Cash Flow multiple (EBITDA multiple)
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