Terminal Value (TV) Definition and How to Find The Value (With Formula)
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Summary:
Terminal Value (TV) is an essential concept in financial analysis, representing the value of a business or investment beyond the projection period. There are two methods for calculating Terminal Value (TV): the Perpetuity Growth Method and the Exit Multiple Method. Calculating Terminal Value (TV) is an essential step in the Discounted Cash Flow (DCF) model, which is widely used in financial analysis.
Introduction
When analyzing a business or investment, it is essential to understand the future value of that asset. Terminal Value (TV) represents the value of an asset beyond the projection period, typically beyond five years. This concept is vital in financial analysis, where the goal is to determine the current value of an asset based on its future cash flows.
This article aims to explain what Terminal Value (TV) is, how it is used in financial analysis, and the two methods for calculating it. We will also provide a step-by-step guide and a formula for calculating Terminal Value (TV) using the Perpetuity Growth Method and the Exit Multiple Method.
Understanding terminal value (TV)
Terminal Value (TV) is the present value of all future cash flows beyond the projection period. It is a critical concept in financial analysis because most businesses or investments have a life beyond the projection period.
There are two methods for calculating Terminal Value (TV):
- Perpetuity Growth Method: This method assumes that the business or investment will continue to grow at a constant rate forever.
- Exit Multiple Method: This method assumes that the business or investment will be sold at the end of the projection period, and its value will be based on a multiple of its earnings or cash flows.
Terminal Value (TV) is an essential component of the Discounted Cash Flow (DCF) model, which is widely used in financial analysis. DCF is a valuation method that calculates the present value of all future cash flows of an asset by discounting them to their present value using a discount rate.
Calculating terminal value (TV)
Here’s a step-by-step guide on how to calculate Terminal Value (TV) using the Perpetuity Growth Method:
- Determine the projected cash flow for the last year of the projection period.
- Determine the perpetual growth rate (g) for the business or investment beyond the projection period.
Calculate the Terminal Value (TV) using the following formula:
TV = (CF * (1 + g)) / (r – g)
Where:
TV = (CF * (1 + g)) / (r – g)
Where:
CF = cash flow for the last year of the projection period
- r = discount rate
Here’s a step-by-step guide on how to calculate Terminal Value (TV) using the Exit Multiple Method:
- Determine the projected earnings or cash flow for the last year of the projection period.
- Determine the appropriate multiple to apply to the earnings or cash flow at the end of the projection period.
Calculate the Terminal Value (TV) using the following formula:
TV = (CF * Multiple) / (1 + r)^n
Where:
TV = (CF * Multiple) / (1 + r)^n
Where:
CF = cash flow for the last year of the projection period
Multiple = the multiple applied to earnings or cash flow at the end of the projection period
r = discount rate
- n = number of years in the projection period
Example calculation of terminal value (TV)
Let’s consider an example to illustrate how to calculate Terminal Value (TV) using the Perpetuity Growth Method and the Exit Multiple Method.
Suppose a business has a projected cash flow of $100,000 in the last year of the projection period. The perpetual growth rate is 2%, and the discount rate is 10.
Here’s how to calculate the Terminal Value (TV) using the Perpetuity Growth Method and the Exit Multiple Method:
Perpetuity growth method
TV = (CF * (1 + g)) / (r – g)
TV = ($100,000 * (1 + 2%)) / (10% – 2%)
TV = $1,428,571.43
Exit multiple method
Suppose the appropriate multiple to apply to the earnings or cash flow at the end of the projection period is 8x.
TV = (CF * Multiple) / (1 + r)^n
TV = ($100,000 * 8x) / (1 + 10%)^5
TV = $469,086.01
In this example, the Terminal Value (TV) calculated using the Perpetuity Growth Method is higher than that calculated using the Exit Multiple Method. This result indicates that the Perpetuity Growth Method assumes that the business will continue to grow indefinitely, whereas the Exit Multiple Method assumes that the business will be sold at the end of the projection period.
FAQs
What is the discounted cash flow (DCF) model?
The Discounted Cash Flow (DCF) model is a valuation method that calculates the present value of all future cash flows of an asset by discounting them to their present value using a discount rate.
What is the perpetuity growth method?
The Perpetuity Growth Method is a method for calculating Terminal Value (TV) that assumes that the business or investment will continue to grow at a constant rate forever.
What is the exit multiple method?
The Exit Multiple Method is a method for calculating Terminal Value (TV) that assumes that the business or investment will be sold at the end of the projection period, and its value will be based on a multiple of its earnings or cash flows.
Key takeaways
- Terminal Value (TV) is the present value of all future cash flows beyond the projection period.
- There are two methods for calculating Terminal Value (TV): the Perpetuity Growth Method and the Exit Multiple Method.
- Calculating Terminal Value (TV) is an essential step in the Discounted Cash Flow (DCF) model.
- The Perpetuity Growth Method assumes that the business or investment will continue to grow at a constant rate forever, while the Exit Multiple Method assumes that the business or investment will be sold at the end of the projection period.
- The appropriate method for calculating Terminal Value (TV) depends on the specific circumstances of the business or investment being analyzed.
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