Terminal Value

Terminal Value captures the value of a company for the period after the explicitly planned forecast period. Because one does not plan each year individually into infinity, the terminal value bundles all later cash flows. In a valuation, it often accounts for the largest part of the result. It is usually derived from a perpetuity with constant growth: the final forecast year's cash flow is grown by the growth rate and divided by the difference between cost of capital and growth rate.

Alternatively an exit multiple is applied to the final year's earnings, which is common in transaction practice and in leveraged buyouts. The sensitivity of this figure is the main reason for caution: because the denominator is the difference between two similar numbers, adjusting the growth rate by half a percentage point changes the value considerably. As a rule of thumb the perpetual growth rate assumed should not exceed long-term growth of the overall economy, since otherwise the company would arithmetically end up accounting for the entire economy. It matters just as much that the final forecast year represents a steady state, with margins, investment and working capital needs consistent with the assumed long-term growth. Both approaches are calculated side by side in practice and checked against each other.

The sensitivity is considerable: at a 9 percent cost of capital, raising the growth rate from 1 to 2 percent increases the terminal value by around 14 percent if the cash flow in the first year after the forecast period remains unchanged.