What is terminal value in discounted cash flow valuation

The discounted cash flow or DCF valuation method is perhaps the most widely used technique in income based business appraisals. If you take a look at the calculation, you will notice that it consists of two parts:

• A discounted forecast of future earnings over a finite time period
• A so-called terminal value calculation

The idea is that the earnings forecast can be accurate only so far into the future. Beyond some point, the earnings of the business may be less predictable. So one makes a leap of faith and assumes that the earnings will continue growing at a constant rate from then on. In this case these earnings can be capitalized in order to represent the residual or terminal value of the business in perpetuity.

An alternative is to use an estimate of a business sale proceeds if a sale is planned some time in the future. The same idea applies, you discount the earnings of the business until the business sale occurs. At that point, the business sale proceeds, i.e. the selling price less transaction expenses, can be capitalized. The overall business value today is the sum of the discounted future income stream and the capitalized sales proceeds value.

Note that just like the terminal value, the sales proceeds figure must be discounted to the present time.

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