Terminal value (finance)

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In finance, the terminal value (continuing value or horizon value) of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.

Finance academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

Security (finance) tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some jurisdictions, the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions, it includes some instruments that are close to equities and fixed income, e.g., equity warrants. In some countries and languages, the term "security" is commonly used in day-to-day parlance to mean any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition.

In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of negative interest rates, when the present value will be more than the future value. Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant, without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds is less than the total amount of money paid to the lender.

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Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. The terminal value is calculated in accordance with a stream of projected future free cash flows in discounted cash flow analysis. For whole-company valuation purposes, there are two methodologies used to calculate the Terminal Value.

Discounted cash flow method of valuing a project, company, or asset using the concepts of the time value of money

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Perpetuity Growth Model

The Perpetuity Growth Model accounts for the value of free cash flows that continue growing at an assumed constant rate in perpetuity. Also, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. This value is divided by the discount rate minus the assumed perpetuity growth rate:

A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence. For example, the United Kingdom (UK) government issued them in the past; these were known as consols and were all finally redeemed in 2015. Real estate and preferred stock are among some types of investments that effect the results of a perpetuity, and prices can be established using techniques for valuing a perpetuity. Perpetuities are but one of the time value of money methods for valuing financial assets. Perpetuities are a form of ordinary annuities.

The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. The term originated with the practice of sending a bank representative to a reserve bank teller window when a bank needed to borrow money.

T0 is the value of future cash flows. This equation is a perpetuity, which uses a geometric series to determine the value of a series of growing future cash flows. To determine the present value of the terminal value, one must discount the Terminal Value at T0 by a factor equal to the number of years included in the initial projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1 + k)5. The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied enterprise value.

Geometric series sum of a finite geometric progression

In mathematics, a geometric series is a series with a constant ratio between successive terms. For example, the series

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

If the growth rate in perpetuity is not constant, a multiple-stage terminal value is calculated. The terminal growth rate can be negative, if the company in question is assumed to disappear in the future.

Exit Multiple Approach

The Exit or Terminal Multiple Approach assumes a business will be sold at the end of the projection period. Valuation analytics are determined for various operating statistics using comparable acquisitions. A frequently used terminal multiple is Enterprise Value/EBITDA or EV/EBITDA. The analysis of comparable acquisitions will indicate an appropriate range of multiples to use. The multiple is then applied to the projected EBITDA in Year N, which is the final year in the projection period. This provides a future value at the end of Year N. The terminal value is then discounted using a factor equal to the number of years in the projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1+k)5. The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied Enterprise Value. Note that if publicly traded comparable company multiples must be used, the resulting implied enterprise value will not reflect a control premium. Depending on the purposes of the valuation, this may not provide an appropriate reference range.

Enterprise value/EBITDA is a popular valuation multiple used in the finance industry to measure the value of a company. It is the most widely used valuation multiple based on enterprise value and is often used in conjunction with, or as an alternative to, the P/E ratio to determine the fair market value of a company.

Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is the present value multiplied by the accumulation function. The value does not include corrections for inflation or other factors that affect the true value of money in the future. This is used in time value of money calculations.

A control premium is an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company in order to acquire a controlling share in that company.

Comparison of methodologies

There are several important differences between the two approaches.

The Perpetuity Growth Model has several inherent characteristics that make it intellectually challenging. Because both the discount rate and growth rate are assumptions, inaccuracies in one or both inputs can provide an improper value. The difference between the two values in the denominator determines the terminal value, and even with appropriate values for both, the denominator may result in a multiplying effect that does not estimate an accurate terminal value. Also, the perpetuity growth rate assumes that free cash flow will continue to grow at a constant rate into perpetuity. Consider that a perpetuity growth rate exceeding the annualized growth of the S&P 500 and/or the U.S. GDP implies that the company's cash flow will outpace and eventually absorb these rather large values. Perhaps the greatest disadvantage to the Perpetuity Growth Model is that it lacks the market-driven analytics employed in the Exit Multiple Approach. Such analytics result in a terminal value based on operating statistics present in a proven market for similar transactions. This provides a certain level of confidence that the valuation accurately depicts how the market would value the company in reality.

On the other hand, the Exit Multiple approach must be used carefully, because multiples change over time. Simply applying the current market multiple ignores the possibility that current multiples may be high or low by historical standards. In addition, it is important to note that at a given discount rate, any exit multiple implies a terminal growth rate and conversely any terminal growth rate implies an exit multiple. When using the Exit Multiple approach it is often helpful to calculate the implied terminal growth rate, because a multiple that may appear reasonable at first glance can actually imply a terminal growth rate that is unrealistic.

In practice, academics tend to use the Perpetuity Growth Model, while investment bankers favor the Exit Multiple approach. Ultimately, these methods are two different ways of saying the same thing. For both terminal value approaches, it is essential to use a range of appropriate discount rates, exit multiples and perpetuity growth rates in order to establish a functional valuation range.

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