Terminal Value Explained: Role & Estimation in DCF Valuation

Imagine you are trying to figure out the total worth of a flourishing fruit tree. You could count all the fruit it will produce this season, and maybe even next season. That’s like forecasting the near-term future, the next few years of cash flow for a business. This is what we do in a Discounted Free Cash Flow, or DCF, valuation. We project how much cash a company will generate in the coming years.

But what about all the fruit the tree will produce for many, many years beyond those initial seasons? A healthy fruit tree can bear fruit for decades. Similarly, a successful business is expected to operate and generate cash for a long time, ideally indefinitely. We can’t precisely predict every single year of fruit or every single year of cash flow stretching into the distant future. That’s where the concept of terminal value, sometimes called horizon value, comes into play.

Terminal value represents the value of all those future cash flows that occur after our explicit forecast period. It’s essentially a lump sum capturing the worth of the business from the end of our detailed projections onwards, assuming it continues to operate. Think of it as representing the value of all the fruit the tree will produce after you stop counting season by season, summarized into one big, estimated value.

Why is terminal value so important? Often, especially for growing companies, the terminal value can make up a large portion of the total valuation derived from a DCF. This is because it encapsulates the long-term earning potential of the business. While the near-term cash flows are important, it’s the enduring ability of the company to generate value far into the future that truly drives its overall worth. Ignoring terminal value would be like only counting the fruit from the first few seasons and completely disregarding the long and productive life of the fruit tree. You would drastically undervalue it.

Now, how do we actually estimate this terminal value? There are a couple of common approaches.

One popular method is the Gordon Growth Model. This method assumes that the company’s free cash flow will grow at a constant rate forever, or at least into the foreseeable future. It’s like assuming our fruit tree will continue to produce fruit at a steady, predictable rate each year after a certain point. The formula for the Gordon Growth Model is relatively straightforward. You take the free cash flow expected in the first year after your explicit forecast period, multiply it by one plus the assumed long-term growth rate, and then divide the result by the discount rate minus the growth rate. The discount rate represents the required rate of return for investors, reflecting the risk of the business. The growth rate is a conservative estimate of how much the company can sustainably grow in the long run. It’s crucial to use a realistic and sustainable growth rate, often linked to the overall long-term economic growth rate to avoid overly optimistic valuations.

Another common method is the Exit Multiple Method. Instead of assuming perpetual growth, this approach estimates the terminal value based on what similar companies are worth when they are bought or sold in the market. Imagine you want to sell your fruit tree orchard. You might look at recent sales of comparable orchards in your area and see what price they fetched relative to their fruit production or revenue. Similarly, in the Exit Multiple Method, we apply a valuation multiple, like a price-to-earnings ratio or an enterprise value-to-EBITDA ratio, observed from comparable companies to our company’s projected financial metric in the final year of our explicit forecast. For example, if comparable companies are trading at 10 times their earnings before interest, taxes, depreciation, and amortization, or EBITDA, we might apply that multiple to our company’s projected EBITDA in the final forecast year to estimate its terminal value. Choosing the right multiple and ensuring the comparable companies are truly similar to the company being valued are critical for this method to be reliable.

Both the Gordon Growth Model and the Exit Multiple Method are estimations, not precise predictions of the future. They are tools to help us reasonably approximate the value of those long-term cash flows beyond our explicit forecast horizon. Ultimately, choosing the appropriate method and the assumptions within each method requires careful judgment and a deep understanding of the company, its industry, and the overall economic environment. Terminal value is a crucial component of DCF valuation, providing a vital link to the long-term potential of a business and ensuring we are considering the full picture of its value, much like appreciating the lifetime fruit-bearing potential of a healthy tree, not just a few seasons’ harvest.