Terminal value in business valuation: some alternatives
If you are using the discounted cash flow method for your business valuation, a key step is to calculate the terminal value. This is the residual value of the company assuming that it will continue operating beyond the earnings projection period.
The idea is that you can predict business earnings only so far into the future. Beyond a certain point the accuracy of forecast becomes questionable. So it is reasonable to make some assumptions about how business will continue going forward.
The constant growth model assumes that the company will continue operating with earnings increasing at a some fixed rate of growth. So instead of discounting the business cash flows indefinitely, you can simply apply a capitalization formula to calculate the terminal value.
While the constant growth model is the usual way to calculate the terminal value, there are some alternatives you may want to consider. Here are some suggestions:
Sum of book value of debt and equity
The terminal value is just the sum of the two. Of course, the main assumption here is that the firm’s book values accurately predict its market values.
Multiple of market to book value
Terminal value = (market / book multiple) x (book value of debt and equity)
Price to earnings ratio formula
Terminal value = Price to earnings ratio x profits + book value of debt.
The profits and book value of debt are estimated as of the end of your earnings forecast period.
EBITDA based ratio formula
Terminal value = EBITDA ratio x expected terminal EBITDA.
The terminal EBITDA is what you expect to see at the end of the cash flow forecast.
Since the discounted cash flow method calculation includes the terminal value explicitly, you can substitute one formula for another in your business valuations.
Discounted Cash Flow Valuation
Here is an example of using the discounted cash flow method that explains how the terminal value enters into the calculation.