Terminal value in financial modelling

Terminal value is the value of a project’s expected cash flows beyond the explicit forecast period. It often makes up a large share of project value in a discounted cash flow valuation, so a sound estimate matters.

Net present value (NPV) values a project or investment from its future cash flows. A firm or project may have an indefinite life, so its value is the NPV of its cash flows for an indefinite period.

Forecasting beyond a certain point is impractical, though. Revenue, costs and industry and economic conditions are hard to predict more than a few years out, which limits how far a forecast can be trusted.

A terminal value captures the value at the end of the forecast period. It brings in the value of cash flows beyond the projection period without forecasting them one by one. We cover it in depth in our Financial Modelling for Corporate Finance course.

Because terminal value often accounts for a large share of total project value, analysts and modellers need to know how it is calculated. The workbook shows the methods below in a project finance model.

Three ways to estimate terminal value

• Multiple of earnings before interest, tax, depreciation and amortisation (EBITDA)
• Perpetuity
• Perpetuity with growth

In practice, academics tend to use the perpetuity growth model, while project financiers favour the exit multiple. The two are different ways of saying the same thing. Whichever you use, test a range of discount rates, multiples and growth rates to set a sensible valuation range.

The EBITDA exit multiple method

The EBITDA multiple method values the enterprise, that is, the business operations only. The terminal value is:

Terminal value=EBITDA (final year) × exit multiple

The present value (PV) of the terminal value is then added to the PV of the free cash flows in the forecast period to give an implied firm value.

The multiple comes from publicly traded comparable companies. This is the simplest method, but depending on the purpose of the valuation the EBITDA multiple may not give a suitable range. Other multiples used for terminal value include:

• Price to earnings (P/E)
• Market to book
• Price to revenue
• Earnings before interest and tax (EBIT)

The perpetuity growth method

The perpetuity growth method assumes free cash flow keeps growing at a constant rate for ever. The terminal value is:

Terminal value=FCF (final year) × (1 + g)r − g

where FCF is free cash flow, g is the stable growth rate and r is the discount rate.

Which growth rate should you use? The constant rate is called the stable growth rate. Past growth is not always a reliable guide, but current and future growth are related: a project growing at 10% now probably has higher growth, for longer, than one growing at 5% a year.

The growth rate is hard to estimate, and an inaccurate one gives the wrong value. Analysts sometimes leave growth out altogether, the perpetuity method, for a more conservative terminal value.

Modelling terminal value in the workbook

The workbook assumes a project with a 12-month construction period and quarterly cash flow projections over 10 years, and shows all three methods. Each needs the EBITDA or free cash flow for the last year of the forecast period. The simplest way to pick it out is a binary (1, 0) flag, as Figure 2 shows.

The terminal value calculation itself is simple. Figure 3 shows the EBITDA multiple method.

The last step is to add the terminal value to the project cash flow before calculating the NPV. In the workbook, the perpetuity method is the one selected.

Terminal value mistakes to avoid

• Take the EBITDA or cash flow for the whole last year of the forecast period. A common mistake is to take only the last quarter or month
• Add the terminal value to the project cash flow before calculating the NPV. The valuation does not stop at the terminal value itself
• Choose a multiple, growth rate and discount rate that suit the project’s risk, because they drive the result
• Show clearly whether the calculation is before or after tax