Role of Terminal Value in DCF
According to studies, there can be a deviation of more than 50% between valuation estimates and observed market values.We believe this lack of accuracy comes from an incomplete understanding of valuation methods and their limitations.
Even the discounted cash flow (DCF) method, one of the most used valuation methods, has a limitation that is often overlooked. This method relies on estimating future cash flows but beyond a certain point, cash flows cannot be reliably estimated.
In this article, we will explore how terminal values help us circumvent this limitation of the discounted cash flow (DCF) method.
Why do we need terminal values in DCF?
In the discounted cash flow (DCF) method, we find a company’s valuation by estimating its future cash flows and then discounting them. These discounted cash flows are summed up to find the company’s value. However, a limitation of DCF is that we can confidently estimate cash flows only for a certain number of years. After this period, it is extremely challenging or, sometimes, downright impossible, to calculate cash flows.
For instance, since startups are high-growth and high-risk entities, there’s no telling what their revenue will be five years later. Established companies have more predictable cash flows. However, even with such companies, valuation analysts would hesitate to put forward revenue and expenditure estimates for a financial year 10 to 15 years down the line.
To work around this limitation, we discount the terminal value which is the estimated value of the company at the end of the forecast period.
How do we calculate terminal values?
Terminal value is meant to represent all cash flows of a business beyond its forecasted period. The two methods that we can take to calculate terminal values are as follows:
Exit multiple method
In the exit multiple method, we establish a market valuation multiple by researching recent funding rounds, mergers and acquisitions (M&As), initial public offerings (IPOs), and earnings results of similar companies. Typically, we establish a market valuation multiple by dividing the valuation of all companies in the market by the market revenue, sales, or any other appropriate financial figure.
The formula for sales market valuation is:
Market valuation multiple = Valuation of all companies in the market/Market sales
Then, we apply the market valuation multiple to the appropriate estimated financial figure for the last year in the forecasted period to arrive at the terminal value.
The terminal value formula in the sales-based exit multiple method is as follows:
Terminal value = Market valuation multiple × Sales of the last year in the forecasted period
Perpetual growth method
The perpetual growth method applies better to valuing established businesses than to startups. It is based on perpetuities, a type of annuity that pays a fixed return indefinitely. In the perpetual growth model, we modify the perpetuity formula to incorporate a steady growth rate.
The formula for calculating perpetuities is:
Perpetuity value=Cash flow/Interest rate or rate of return
When we incorporate growth rate into perpetuity, the formula changes to this:
Perpetuity value=Cash flow/(Interest rate-Growth rate)
In the perpetual growth method, the interest rate is replaced by the investors’ required rate of return. We also adjust the free cash flow to the firm for the last year of the forecasted period as per the growth rate. Hence, the terminal value formula in the perpetual growth models looks like this:
Terminal value=FCFn ×(1+Growth rate)/Required return rate-Growth rate
Here, FCFn is free cash flow to the firm in the last year of the forecast period.
Of the two methods, the exit multiple method is more practical and is favored by investors. This method allows investors to incorporate market expectations into the valuation. Also, the assumption that a company will always exist and always grow at the same rate may seem impractical to most investors.
Terminal value calculation example
As per the financial projections for Cloudrift, a cloud storage solution providing startup, its sales and free cash flow to the firm in the last year of the forecasted period are $2 million and $1.5 million. The investors are expecting returns of 15% and the estimated growth rate is 6%.
Let us calculate the terminal value for Cloudrift.
Terminal value as per perpetual growth model = $1.5 million × (1+6%)/15%-6%
= $1.59 million/9%
= $17.67 million
After some research on funding rounds and mergers and acquisitions (M&As), we could gather the following facts.
Based on these figures, the market valuation multiple will be = Valuation of all companies in the market/Total sales
= $80 million/$28 million
= 2.91
Now, all we need to do is calculate Cloudrift’s terminal value based on the exit multiple method.
Terminal value as per exit multiple method = 2.91 × $2 million
= $5.82 million
Eqvista- Accurate valuations for sound investment decisions!
Terminal values are an important component of the discounted cash flow (DCF) method. They allow us to work around the limitation of being unable to reliably estimate cash flows beyond a certain point. We can estimate terminal values through the exit multiple method or the perpetual growth method.
The perpetual growth method applies better to established companies since it assumes perpetual existence and steady revenue growth. Since these assumptions are not practical, investors prefer the exit multiple method as it also allows them to incorporate market expectations into their valuations.
If you need accurate valuations, for fundraising or tax compliance reasons, consider relying on Eqvista’s team of NACVA-certified valuation analysts. We deliver accurate valuations in comprehensive reports that enable you to unlock your company’s true potential. Contact us to know more!
