Take a look at our considerations on terminal value calculation in DCF analysis.
Terminal Value captures the value of a business beyond the projection period. Common methods to project the terminal value are as follows:
- Applying a perpetual growth rate to the earnings/cash flows at the end of the projection period.
Terminal Valuet = Free Cash Flowst *(1 + Perpetual Growth Rate)/(Discount Rate)
- Applying an exit multiple to the earnings/cash flows at the end of the projection period.
Perpetual Growth Rate is generally considered equivalent to the growth rate of the economy in which the company operates. In perpetuity, a business is less likely to grow at a faster rate than the overall economy.
It is important to ensure that the earnings in the final year of the projection period are normalized in terms of revenue growth and margins as the business cannot be expected to grow at very high rates or maintain higher margins in perpetuity due to factors such as market conditions and competition.
Similarly, the free cash flows in the final year of the projection period should be normalized in terms of expected working capital and capital expenditure going forward.
For high growth and early stage companies, the high growth period can be expected to continue after the projection period. In such cases, the use of perpetual growth rate to determine terminal value would not be appropriate.
For high growth companies, the terminal value can be forecasted using a two stage H-Model which assumes an initial higher growth period for a few years after the projection period and lower growth period at the end of which the earnings of the business are expected to stabilize and grow further at a perpetuity growth rate.
Terminal value usually makes up a larger portion of the total enterprise value derived from the DCF analysis. As a result, it is important to do a sensitivity analysis of the terminal value to key inputs such as growth rates and discount rates. This helps determine the reliability of the DCF results.