Terminal value (finance)

In finance, the terminal value (continuing value or horizon value) of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.

Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. The terminal value is calculated in accordance with a stream of projected future free cash flows in discounted cash flow analysis. For whole-company valuation purposes, there are two methodologies used to calculate the Terminal Value.

The Perpetuity Growth Model accounts for the value of free cash flows that continue growing at an assumed constant rate in perpetuity. Also, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. This value is divided by the discount rate minus the assumed perpetuity growth rate:

T₀ is the value of future cash flows. This equation is a perpetuity, which uses a geometric series to determine the value of a series of growing future cash flows. To determine the present value of the terminal value, one must discount the Terminal Value at T₀ by a factor equal to the number of years included in the initial projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1 + k)⁵. The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied enterprise value.

If the growth rate in perpetuity is not constant, a multiple-stage terminal value is calculated. The terminal growth rate can be negative, if the company in question is assumed to disappear in the future.

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