Terminal Value Definition
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.
A Little More on What is Terminal Value
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 firm’s 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 firm’s 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.
References for Terminal Value
- Academic Research on Terminal Value
Equity valuation employing the ideal versus ad hoc terminal value expressions, Courteau, L., Kao, J. L., & Richardson, G. D. (2001). Contemporary accounting research, 18(4), 625-661.
A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model, Penman, S. H. (1998). Review of Accounting Studies, 2(4), 303-323.
Terminal value techniques in equity valuation: implications of the steady state assumption, Levin, J., & Olsson, P. (2000). SSE/EFI Working Paper Series in Business Administration, 7.
An optimal dividends problem with a terminal value for spectrally negative Lévy processes with a completely monotone jump density, Loeffen, R. L. (2009). Journal of Applied Probability, 46(1), 85-98.
Optimal dividend problem with a terminal value for spectrally positive Lévy processes, Yin, C., & Wen, Y. (2013). Insurance: Mathematics and Economics, 53(3), 769-773.
Terminal value or present value in capital budgeting programs, Jean, W. H. (1971). Journal of Financial and Quantitative Analysis, 6(1), 649-651.
Dependence of the optimal risk control decisions on the terminal value for a financial corporation, Taksar, M. I. (2000). Annals of Operations Research, 98(1-4), 89-99.
Comment on “Terminal value, accounting numbers, and inflation” by Gunther Friedl and Bernhard Schwetzler, Bradley, M. H., & Jarrell, G. A. (2011). Journal of Applied Corporate Finance, 23(2), 113-115.
A comparison principle for terminal value problems in ordinary differential equations, Hallam, T. G. (1972). Transactions of the American Mathematical Society, 169, 49-57.
The Terminal Value and Inflation Controversy, Kiechle, D., & Lampenius, N. (2012). Journal of Applied Corporate Finance, 24(3), 101-107.