Terminal Value - Explained
What is Terminal Value?
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Table of ContentsWhat is Terminal Value?How Does Terminal Value Work?Perpetuity Method
What is Terminal Value?
Terminal value (TV) is a term in finance that refers to all future cash flows in an asset valuation. TV represents the value of all future cash flows, this is a sum of an investment beyond its forecast. Asset valuation is a process that examines the fairness of market value of assets, this is determined using book values, absolute valuation models. Discounted cash flow analysis and others. Through the asset valuation model, Terminal value presents returns that will occur in the future but are difficult to predict or forecast. Terminal value can occur in a multi-stage discounted cash flow analysis, this allows cash flow projections into several years.
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How Does Terminal Value Work?
In the calculation of the terminal value of a firm, discounted cash flow (DCF) is vital. DCF is a method or formula used in calculating Terminal Value of the firm, this is the estimate of the value of an investment based on future cash flows. DCF is a method that posits that an asset's value is equal to all the future cash flows that a firm can get for the asset. DCF forecasts the continuity of growth of a firm and that the return on capital will be more than the cost of capital. DCF analyses the present value of the expected future cash flow of an investment or security at a discounted rate.
Aside from discounted cash flow method, perpetuity method is another approach used in calculating a firms terminal value. Given that it is difficult or impossible to determine the precise time when a company may cease operations, the perpetuity growth method gives the assumption that a firms cash flows will grow at a stable rate forever, starting at some point in the future. Using the perpetuity method, the future cash flows of a company at a stable growth rate can be estimated. The perpetuity method measures all future cash flows using a company's steady growth rate which then gives the terminal value of the firm. The discounted cash flow method and perpetuity growth method are not applicable in every calculation of terminal value. For instance, if a terminal value needs to present the net realizable value of a firm at a specific time, the exit multiple method will be used. The exit multiple method assumes that a company has the tendency of being sole off at that end of the projection period. The duration of projection vary from company to company. Exit multiples give an estimate of fair prices using Enterprise Value/EBITDA which is arrived at by multiplying financial statistics (sales, profits, or earnings before interest, taxes, depreciation, and amortization) by a factor seen in firms recently acquired.