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Concept
Terminal value (finance)
Summary
In finance, the terminal value (also known as “continuing value” or “horizon value” or "TV") of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period; see Forecast period (finance).
Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.
Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows.
The terminal value is calculated in accordance with a stream of projected future free cash flows in discounted cash flow analysis.
For whole-company valuation purposes, there are two methodologies used to calculate the Terminal Value.
Gordon Growth Model
The Perpetuity Growth Model accounts for the value of free cash flows that continue growing at an assumed constant rate in perpetuity;
essentially, a geometric series which returns the value of a series of growing future cash flows
(see Dividend discount model #Derivation of equation).
Here, the projected free cash flow in the first year beyond the projection horizon (N+1) is used.
This value is then divided by the discount rate minus the assumed perpetuity growth rate
(see Sustainable growth rate #From a financial perspective ):
D0 = Cash flows at a future point in time which is immediately prior to N+1, or at the end of period N, which is the final year in the projection period.
k = Discount Rate.
g = Growth Rate.
T0 is the value of future cash flows; here dividends. When the valuation is based on free cash flow to firm then the formula becomes ,
where the discount rate is correspondingly the weighted average cost of capital.
Official source
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