http://valuationacademy.com Terminal Value in a Discounted Cash Flow Approach — Valuation Academy

Terminal Value in a Discounted Cash Flow Approach

Terminal value is defined as the value of an investment at the end of a certain period, incorporating a specified rate of interest.  Calculating the terminal value uses the same formula as that for calculating compound interest:

 

TV = P x (1 + r)^(t)

 

Where:

TV = the total amount

P = the principle amount

r = interest rate

t = period of time

 

Calculating terminal value allows companies to forecast future cash flows much more easily.  When calculating terminal value it is important that the formula is based on the assumptions that the cash flow of the last projected year will stabilize and continue at the same rate forever.

There are two approaches to terminal value that must be taken into consideration.  The Terminal Multiple is a term used in discounted cash flow analyses and valuation.  It is the final multiple that is projected for a specified period and is used to predict terminal value.  This is just one method of conducting a discounted cash flow analysis.  The other method is referred to as the Terminal Growth or Gordon Growth.  The Gordon growth method can be used instead of the terminal multiple method when running a discount cash flow analysis.  The basic assumption of this method is that a company will continue to grow and generate free cash flows at a consistent rate indefinitely.  This rate is generally very low, usually trending in line with GDP growth or inflation.  When calculating terminal value using a DCF analysis, the Gordon growth method uses the following formula:

 

EBITDA x ((1 + Terminal Growth Rate) / (WACC – Terminal Groth Rate))

 

Where:

EBITDA = Earnings before Interest, Taxation, Depreciation & Amortization

WACC = Weighted Average Cost of Capital

 

When using this method in conducting a DCF (discount cash flow) analysis, it is important to consider that the Present Value of the Terminal Value must use the standard discount period rather than the mid-year discount period.

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