Effect of terminal value on the discounted cash flow valuation
One of the central valuation methods under the income approach is the Discounted Cash Flow technique. To apply this method in your business valuation you would need to work up the following key inputs:
- Forecast of business cash flows
- Discount rate measuring the business risk
- Business long-term value, known as the terminal value
While the future cash flows and business risk assessment usually come from the business financial plan, the calculation of the terminal value requires a leap of faith. The idea is that you can predict business earnings only so far into the future.
You may feel that the business will continue running as a going concern but have difficulty predicting its future earnings. The discounted cash flow method lets you get around this problem by including the terminal value in the calculation. This represents the residual value of the business beyond the earnings forecast period.
There are a number of situations that business owners or their advisors may handle differently in this respect. For example, they may have a clear plan toward selling the business and the kind of money the transaction will likely bring.
On the other hand, the owners may decide to wind up the operations after some time and either sell the remaining assets or use them up prior to the shutdown.
Each of these scenarios may greatly affect what the business is worth today. Other things being equal, the difference is in the terminal value of the company.
If the firm is to continue as a going concern, you can capitalize the future earnings accounting for the expected earnings growth rate and calculate the terminal value.
Alternatively, you can incorporate the future business selling price directly into your valuation. In other words, the residual business value to the current owners is the discounted future selling price.
If the business is to be closed after some time, then the terminal value is just the salvage value of the remaining business assets. If you do not expect significant assets to remain on hand at that point in time, then the terminal value is zero.
Example: Long term planning and business value
Let’s see how these considerations can affect the result of your business valuation. Consider an example company with the following 5 year net cash flow forecast:
- Year 1: $95,377
- Year 2: $101,231
- Year 3: $107,085
- Year 4: $112,940
- Year 5: $118,794
Note that the average cash flow growth rate for this business is 5.47% annually.
We further assess the business risk and calculate the discount rate of 29.58% and capitalization rate of 24.11%. Next, consider the business value under each long-term scenario as follows:
Case 1: Valuation of a business as a going concern
Here we make the assumption that the company will continue operating as usual past the earnings forecast period. The terminal value is then calculated to be $519,605. Applying the discounted cash flow valuation to these inputs gives us the following business value result:
Business value as a going concern: $397,913
Case 2: Valuation of a business that is sold at the end of the earnings forecast period
Under this scenario, the business owners believe that they can sell the business for $750,000 five years down the road. The resulting business valuation now becomes:
Business value: $460,978
Case 3: Business valuation for a company that is shut down in 5 years
In this situation the business owners opt to close the business at the end of the earnings forecast period. They intend to use up the business assets so that they will have no salvage value then. The company is basically worth the present value of the cash flows expected from the business over the 5 year period. Using the discounted cash flow method again, we get the following result:
Business value: $255,686
Business value depends on your assumptions
Note the sharp differences in the business valuation results we get under these different scenarios. Clearly, the decisions you make today can have far reaching consequences on what the business is worth.