Financial officers are tasked with determining what the value of the company is at specific times. Most likely you’ll estimate a range of values rather than a firm figure, because there are so many variables to consider. Income, asset-based and market valuations are popular approaches. Often, cash flow is a key determinant when a business owner is considering a sale of the business. But what time period do you use when figuring out the aggregate cash flows that lead to an appropriate price range for the company? One method is to determine terminal value.
Terminal value is the present value at a future point in time. Consider that it is unlikely that you would estimate cash flows forever; you need to pick a termination point upon which to set the value. There are two primary ways to categorize the value of the business: 1) a calculation of asset values if sold at a particular time, called the Exit Multiple Approach or 2) a formula that accounts for cash flows in perpetuity, called the Perpetuity Growth Model.
Exit Multiple Approach
This method assumes a liquidation value in the terminal year. One way to arrive at that estimate is to calculate the book value of the assets, adjusted for inflation. This accounts only for the disposal income received when the assets are sold. When performing this calculation, the assumptions needed are the estimated book value in the terminal year, the useful life of the assets at that point in time, and the inflation rate from the current year to the terminal year.
The formula for the book value looks like this:
Liquidation Value = Estimated Terminal Year Book Value x (1+inflation rate) avg. asset life
The challenge here is that the multiples you include may not remain consistent or reflect historical multiples. One way to overcome this challenge is to use a set of implied growth rates to determine various multiples then arrive at an average value.
Perpetuity Growth Model
This method uses cash flow discounting from the terminal year to the current year. You must determine whether growth can be expected to be constant over time and what the cost of capital will be in the terminal year. The model incorporates a geometric series of factors to indicate the growth rate.
The formula for calculating the cash flows looks like this:
Terminal Value = Future Cash FlowsN+1 / (b-c)
In this equation n+1 is the final year of projection, b is the discount rate and c is the growth rate. The challenge here is that, in many cases, impacts on cash flow cannot be fully determined at the time you’re calculating the terminal value.
When estimating terminal value, it is recommended that you project out only 3-5 years, as the assumptions may be questionable at best any time after that. Economic uncertainties, political effects and environmental impacts can all play a part in the actual value of the business in the future. Because of this, many forecasters will use the terminal value as worst-case scenario to determine true business valuation.
So which method should you choose to determine terminal value? One factor to consider is the yield from assets. If they are being used as efficiently as possible, the business should be generating optimal cash flows, so the Perpetuity Growth Model should be considered; however, if the assets comprise a significant part of the enterprise value, then the Exit Multiple Approach may be more useful. Either way, be sure to use the most conservative assumptions in order to generate the most accurate valuation.