Terminal Value
What is Terminal Value?
Terminal value is a concept of valuation that is used to estimate the worth of an investment or firm at the terminal end of a certain projection period with the assumption that it will continue indefinitely. It assumes the "future worth" of cash flows beyond the long-term projection period, which is normally used in valuation models like discounted cash flow (DCF) analysis. It's like trying to gauge how valuable a business would be, for example, in 10 years if the business simply keeps operating as normal.
How terminal value is calculated?
Terminal value can be usually estimated using either one of these methods:
Gordon Growth Model (Perpetuity Growth Method):
Assumes the cash flows of the business increase at an exact rate in perpetuity.
Terminal Value = (Cash Flow Final Year × (1 + Growth Rate)) ÷ (Discount Rate − Growth Rate)
- Last Year Cash Flow: Projected cash flow in the last year of the projection.
- Growth Rate: Conservative long-term growth rate (say, 2-3%, perhaps tied to Indian GDP growth).
- Discount Rate: Rate of discounting money over time (say, cost of capital).
Example: Suppose the terminal year cash flow of the company is ₹100 crore with growth rate 2% and discount rate 10%, the terminal value would be (₹100 crore × 1.02) ÷ (0.10 − 0.02) = ₹1,275 crore.
Exit Multiple Method
Begins with the assumption that the company is being sold towards the end of the forecasting period for a multiple of a metric such as EBITDA.
Terminal Value = Final Year's Metric (for example, EBITDA) × Exit Multiple
Example: Suppose last year company EBITDA is ₹50 crore and industry exit multiple is 8x, so terminal value will be ₹50 crore × 8 = ₹400 crore.
Why It Matters
Terminal value can be a major part of a firm's total value within a DCF model in many cases, especially for firms with a high growth phase. In India, as in sectors like IT, pharma, and renewable energy, growth horizons are usually extended, so terminal value helps investors and analysts to estimate the value of the cash flows in the future, which is essential for making investment or acquisition decisions.
Examples in Practice
- Tech Company: A Bengaluru SaaS company projects ₹200 crore cash flow in year 10. With a growth rate of 2.5% and discount rate of 12%, its terminal value is (₹200 crore × 1.025) ÷ (0.12 − 0.025) = ₹2,157 crore.
- Pharma Company: A pharma company based in Mumbai expects ₹80 crore EBITDA in year 10. With the industry's 10x exit multiple, its terminal value would be ₹80 crore × 10 = ₹800 crore.
- Renewable Energy: A solar company in Gujarat expects ₹150 crore cash inflow in year 10. Assuming growth rate of 3% and discount rate of 11%, its terminal value would be (₹150 crore × 1.03) ÷ (0.11 − 0.03) = ₹1,931 crore.
Key Takeaways
- Highest Contribution: Terminal value contributes up to 50-80% of the contribution of a DCF valuation, especially in growth-conservative Indian companies.
- Sensitivity to Assumptions: Small alterations in growth or discount rates yield staggering effects on terminal value, demanding precise estimates.
- Industry Applications: Indian growth-high industries (such as green energy, technology) depend substantially on terminal value in order to carry out adequate valuations.
Advantages of Using Terminal Value
- Long-Term Focus: Seizes the value of cash flows outside short-term projections, needed for long-term businesses.
- Valuation Accuracy: Enhances DCF models through a company's long-term potential, common among India's startups.
- Flexibility: Is adaptable in numerous industries with growth rates or multiples.
Limitations
- Risks in Assumptions: Unrealistically high growth rates or low discount rates lead to terminal value blowing up and overestimation.
- Uncertainty: Estimating cash flows or multiples decades ahead is difficult, especially in volatile markets like the Indian market.
