Investing for Beginners , investing

Terminal value calculation

In financial practice few methods are used to determine terminal value:

1. Perpetuity value model is the most popular method among analysts and the most appropriate when a stable cash flow can be predicted. 

Terminal value = Cash flow of the perpetual year / (Discount rate – Growth rate)

Cash flow of perpetual year is the free cash flow that can be generated by asset. In case of business valuation cash flow is equal to previous year cash flow plus annual growth. However, in most cases previous free cash flow should be also adjusted according to working capital changes and investments in assets while these numbers for previous year and for terminal year usually are different. The influence of working capital changes and capex for terminal year cash flow should depend on terminal Growth rate.

Growth rate should be some percentage that represents the perpetual growth over very long period. Depending on the business sector this growth can be 1%-4% under normal inflation conditions. 

Discount rate can be determined by several methods but WACC (weighted average capital cost) is the most appropriate one. 

2. Relative valuation is based on valuation multiples as EV/S, EV/EBITDA, P/Bv or others. Basically terminal value is calculated in the same way as current value is calculated using relative valuation. However, historical approach for average industry ratios can be used as well. 

3. Asset sale value method also can be used for terminal value determination. The previous two methods are more popular, but sometimes, when the object is very liquid or should turn in to liquid one in the future, his book value can be used.