Terminal value is the value of a security or a project at some future date beyond which more precise cash flows projection is not possible. It is also called horizon value or continuing value.
Terminal value is an important input in the multi-stage discounted cash flow models. Discounted cash flow models project cash flows into future and then discount those to find the present value of the security or the project. Precise cash flow projections can be made only into near future. Terminal value represents time t value of the remaining cash flows that occur far into future. Terminal value is further discounted to find its present value at time 0.
One approach to calculation of terminal value assumes that the project generates a perpetual uniform stream of cash flows beyond time t. Under this approach, present value of perpetuity formula is used to calculate the terminal value:
|Terminal Value =||Annual Cash Flow Beyond Time t|
|Required Return − Growth Rate|
Another approach uses relative valuation. Under this second approach, terminal value equals some multiple of its sales, EBIT, EBITDA, or free cash flow, etc. The benchmark multiples are based on the company's industry and competitors. For example, the terminal value of Coca Cola Company in 30 years can be estimated as the product of Coca Cola Company EBITDA and EV/EBITDA ratio of PepsiCo or average EV/EBITDA for the industry.
You work as financial analyst in Ekuiti Nasional Bhd in Kuala Lumpur. Your next task is valuing a minority stake in Petroasia using a multi-stage dividend discount model. The first stage involves more precise year on year projections for next 5 years. From 6th year onwards a growth rate of 3% is built into the model forever. Free cash flow at the end of 6th year is expected to be MYR 2 billion. The applicable required rate of return is 11%. Find the terminal value using the discounted cash flow method. Double check your valuation with a relative value estimate based on EV/EBITDA multiple. Petroasia EBITDA for 6th year is MYR 6 billion, and average EV/EBITDA multiple that prevails in the industry is 4.5.
|Terminal Value Using Discounted Cash Flow =||MYR 2 billion||= MYR 25 billion|
|11% − 3%|
Terminal Value Using Relative Value
= EBITDA × Benchmark EV/EBITDA ratio
= MYR 6 billion × 4.5
= MYR 27 billion
Written by Obaidullah Jan