When analyzing a company’s financials, one of the most important concepts to understand is terminal value. Terminal value is the estimated future cash flow of a company after a specific period of time, typically 5-10 years. The purpose of calculating terminal value is to estimate the value of a company beyond the forecast period.
There are two methods for calculating terminal value: the multiples method and the discount rate method. The multiples method uses market multiples (such as P/E ratios) to estimate the value of a company. The discount rate method discounts the estimated future cash flows by an appropriate rate (such as the WACC).
The Multiples Method
The multiples method is the most common method for estimating terminal value. To calculate terminal value using this method, you first need to determine the appropriate multiple to use. This can be done by looking at comparable companies or by using industry averages. Once you have determined the appropriate multiple, you simply need to apply it to the forecasted cash flows for the relevant period.
For example, let’s say you are trying to determine the terminal value of Company XYZ. After looking at comparable companies and industry averages, you determine that the appropriate P/E ratio to use is 15. You then apply this P/E ratio to Company XYZ’s forecasted cash flows for year 6, which are $100 million. This results in a terminal value of $1.5 billion.
The Discount Rate Method
The discount rate method is another common way to estimate terminal value. This method discounts the estimated future cash flows by an appropriate discount rate (such as the weighted average cost of capital (WACC)). The result is an estimate of what those cash flows would be worth today.
To continue with our example from above, let’s say you want to calculate Company XYZ’s terminal value using the discount rate method. Assume that Company XYZ has a WACC of 10%. To calculate the terminal value, you would discount each of Company XYZ’s forecasted cash flows for years 6-10 by 10%. This would give you an estimate of what those cash flows would be worth today.
In short, terminal value is an important concept in financial analysis because it allows analysts to estimate the future cash flow beyond the forecast period. There are two methods for calculating terminal value: the multiples method and discount rate method. The choice of which method to use depends on various factors such as availability of data and personal preference.
-Rick Adams Current Yield Blog Post