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What is Terminal Value in Finance?

Updated: Jan 6, 2023

Terminal value is a projection of the future value of a company, investment, or asset beyond a specific point in time. It is used to estimate the total value of an investment at a point in the future, based on assumptions about future cash flows, the cost of capital, and the expected rate of return.


There are several methods that can be used to calculate terminal value, including the perpetuity growth method, the exit multiple method, and the dividend discount model. The specific method used will depend on the characteristics of the investment and the available information.


Terminal value is often used in financial modeling to estimate the intrinsic value of a company or investment. It is typically calculated as part of a discounted cash flow (DCF) analysis, which involves forecasting the expected cash flows of an investment over a certain period of time and then discounting those cash flows back to the present to account for the time value of money. The terminal value is then added to the present value of the expected cash flows to arrive at the total intrinsic value of the investment.


It is important to note that terminal value is an estimate and is subject to uncertainty and changing assumptions. As a result, it should be used with caution and should be considered as part of a larger, comprehensive analysis of an investment.


Terminal Value Example & Calculation


Here is an example of how terminal value might be calculated using the perpetuity growth method:

Assume that a company is expected to generate annual free cash flows of $500,000 for the next 5 years, and that the cost of capital for the company is 10%. The terminal value of the company can be calculated as follows:

Step 1: Determine the terminal growth rate. Let's assume that the terminal growth rate is 3%.

Step 2: Calculate the terminal value. Using the formula for the perpetuity growth method, the terminal value can be calculated as follows: Terminal value = (Free cash flow * (1 + Terminal growth rate)) / (Cost of capital - Terminal growth rate)

Plugging in the values from the example, the terminal value is:

Terminal value = ($500,000 * (1 + 3%)) / (10% - 3%)

Terminal value = $16,666,667

This means that the terminal value of the company is estimated to be $16,666,667 beyond the 5-year forecast period. This value would then be added to the present value of the expected cash flows for the next 5 years to arrive at the total intrinsic value of the company.

It is important to note that this is just one example of how terminal value might be calculated, and there are other methods that can be used as well. The specific method used will depend on the characteristics of the investment and the available information. Terminal value is an estimate and is subject to uncertainty and changing assumptions, so it should be used with caution and considered as part of a larger, comprehensive analysis of an investment.


What is Terminal Value Formula?


There are several methods that can be used to calculate terminal value, including the perpetuity growth method, the exit multiple method, and the dividend discount model. Here is the formula for the perpetuity growth method:


Terminal value = (Free cash flow * (1 + Terminal growth rate)) / (Cost of capital - Terminal growth rate)


In this formula, the terminal value is the projected value of a company, investment, or asset beyond a specific point in time. The free cash flow is the cash that is available to the company after it has paid all of its expenses and made all necessary investments. The terminal growth rate is the expected rate of growth of the free cash flow beyond the forecast period. The cost of capital is the required rate of return that an investor would expect for taking on the risk of investing in the company.


To use this formula, you would need to estimate the free cash flow for the forecast period, determine the terminal growth rate, and calculate the cost of capital. Then, you can plug these values into the formula to calculate the terminal value.


It is important to note that terminal value is an estimate and is subject to uncertainty and changing assumptions. As a result, it should be used with caution and should be considered as part of a larger, comprehensive analysis of an investment.


Why Calculate Terminal Value?


Terminal value is often used in financial modeling to estimate the intrinsic value of a company or investment. It is calculated as part of a discounted cash flow (DCF) analysis, which involves forecasting the expected cash flows of an investment over a certain period of time and then discounting those cash flows back to the present to account for the time value of money. The terminal value is then added to the present value of the expected cash flows to arrive at the total intrinsic value of the investment.


Calculating terminal value is useful because it allows investors to estimate the future value of an investment beyond the forecast period. This can be particularly useful for investments with long-term growth potential, such as young companies or assets with a long useful life.


By projecting the value of an investment beyond the forecast period, investors can get a more complete picture of the potential returns on their investment.

Terminal value can also be useful for comparing the intrinsic value of different investments.


By comparing the terminal value of different investments, investors can get a sense of which investments are likely to generate the most value over the long term.


What is Terminal Value in Internal Rate of Return(IRR)


The terminal value (TV) refers to the present value of all future cash flows after a specific point in time. It is used in discounted cash flow (DCF) analysis to calculate the internal rate of return (IRR) of an investment or project.

The IRR is the rate at which the sum of the discounted future cash flows equals the initial investment. It is a measure of the profitability of an investment and is commonly used to evaluate the potential return of an investment or project.


The terminal value is important in DCF analysis because it captures the value of an investment beyond the projection period. It is calculated using one of two methods: the perpetual growth method or the exit multiple method.


In the perpetual growth method, the terminal value is calculated using the following formula:

TV = FCFn / (WACC - g)

Where:

  • FCFn is the free cash flow in the final year of the projection period

  • WACC is the weighted average cost of capital

  • g is the assumed perpetual growth rate of the company or project


In the exit multiple method, the terminal value is calculated by applying a multiple to the company's or project's projected EBITDA (earnings before interest, taxes, depreciation, and amortization) in the final year of the projection period.


The terminal value is then added to the sum of the discounted cash flows in the projection period to calculate the total value of the investment or project. The IRR is then calculated by solving for the discount rate that makes the present value of the total cash flows equal to the initial investment.


What is Terminal Value in Real Estate?

In real estate, the terminal value refers to the estimated value of a property at the end of a projection period, such as the expected selling price of a property at the end of a hold period.


Like in the context of finance, terminal value in real estate is used in discounted cash flow (DCF) analysis to calculate the internal rate of return (IRR) of an investment. In real estate, the IRR is a measure of the profitability of an investment property and is commonly used to evaluate the potential return on investment.


In real estate DCF analysis, the terminal value is calculated using one of two methods: the perpetual growth method or the comparable sales method.


In the perpetual growth method, the terminal value is calculated using the following formula:

TV = NOI / (Discount rate - Growth rate)


Where:

  • NOI is the net operating income in the final year of the projection period

  • Discount rate is the required rate of return on the investment

  • Growth rate is the assumed perpetual growth rate of the property

In the comparable sales method, the terminal value is calculated by applying a multiple to the property's net operating income (NOI) in the final year of the projection period. The multiple is based on the sale prices of similar properties in the same market.

The terminal value is then added to the sum of the discounted cash flows in the projection period to calculate the total value of the property. The IRR is then calculated by solving for the discount rate that makes the present value of the total cash flows equal to the initial investment.


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