Business Valuation Glossary

Terminal Value

Definition

The residual value of a business at the end of a discrete income projection period used in the Discounted Cash Flow (DCF) business valuation method.

What It Means

Discounted Cash Flow requires income stream projection over a finite period of time. If the business continues operating beyond this point in time, the residual business value must be accounted for.

It is what the business is worth above and beyond the present value of the projected income stream. This value represents a key input into the business valuation and is referred to as the terminal value. There are two models for estimating terminal value: the perpetuity growth model and the exit multiple model.

Perpetuity Growth Model

Also known as the Gordon Growth Model, this model of terminal value assumes the business will continue operating indefinitely.

The terminal value can be computed using the perpetuity growth model by the following formula:

Terminal Value = \frac{{CF}_{n} (1 + g)}{d - g}

Where CF_n is the cash flow expected to be received in the last period of the forecast (n), d is the discount rate, and g is the expected growth rate past the forecast period. The difference between the discount rate and the expected cash flow growth rate in the denominator above is the capitalization rate.

Note that the last period of the forecast must not be negative. This can result in a negative terminal value, which is an economically nonsensical result. (If you're using ValuAdder Business Valuation Software, it will display an alert if this happens.)

Perpetuity Growth Example

Assume that the business cash flow will be $150,000 in year 5. Assume further that the cash flow can be expected to grow annually at the rate of 5% going forward. If your discount rate is 25%, then the terminal value is:

Terminal Value = \frac{$150,000 (1 + 0.05)}{0.25 - 0.05} = $787,500.00

The capitalization rate in this case is 20%, which is the difference between the discount rate of 25% and the expected average growth rate of 5%.

Please note that your choice of the capitalization rate is significant when determining the terminal value. The above example indicates that the business value is $\frac{787,500}{150,000} = 5.25$ times its cash flow in year 5.

Exit Multiple Model

This model of terminal value assumes that the company will be sold at some multiple of one of its financial performance metrics, such as EBITDA or gross revenue, at the end of the forecast period. The formula is simple:

Terminal Value = {Financial Metric}_{n} \times Exit Multiple

You'll need to choose:

Financial Metric_n, a financial metric (such as EBITDA or gross revenue) appropriate to your situation for the final forecast period (n).
Exit Multiple, a defensible market multiple that you expect will be supported by future market conditions, for example 5 × EBITDA.