ValuAdder Business Valuation Blog

Do you plan on using a Discounted Cash Flow (DCF) analysis in your business valuation? Then you need to estimate the Terminal Value (TV) – a crucial step in determining the present value of a business beyond the forecasted period. Often, the Terminal Value accounts for the majority of a company’s total value, particularly for businesses with a significant long-term earnings upside.

There are two primary methods to calculate the Terminal Value: the Perpetuity Growth Model and the Exit Multiple Model. In this post, we’ll dive into the formulas and offer a comparison with examples to show how each model works.

The Perpetuity Model (Gordon Growth Model)

The Perpetuity Growth Model assumes that a company’s free cash flows will grow indefinitely at a constant rate. The formula for Terminal Value using the perpetuity model is:

\(TV = \frac{CF_{n} \, \times \, (1 \, + \, g)}{d \, – \, g} \)

Here \(TV\) is the Terminal Value, \( CF_n \) is the cash flow forecast in year n, \(d\) is the discount rate, and \(g\) is the long-term earnings growth rate.

A common problem with the Perpetuity Growth Model for calculating Terminal Value is overstated earnings growth rate. This can make the capitalization rate in the denominator – calculated as the discount rate minus the growth rate – too small or even negative.

As a result, you get an inflated or mathematically invalid Terminal Value, which misrepresents the true long-term value of the business. If you opt for using the Perpetuity Growth Model, pay special attention to selecting both the discount rate and the earnings growth rate to ensure that the capitalization rate remains positive and realistic.

This careful calibration is essential to producing a realistic valuation scenario that accurately reflects sustainable earnings growth and risk for the company going forward.

Example:

Let’s assume we are calculating the Terminal Value for a company with the following numbers:

\( CF_5 \) (Year 5, end of forecast): $100 million

Annual earnings growth rate (g): 3%

Discount rate (d): 8%

The Terminal Value calculation would be:

\(TV = \frac{100 \, million \, \times \, (1 \, + \, 0.03)}{0.08 \, – \, 0.03} = 2,060 \,  million \)

Thus, the Terminal Value using the Perpetuity Model is $2.06 billion.

The Exit Multiple Model

The Exit Multiple Model estimates the Terminal Value by applying a multiple (often derived from market comparables) to a financial metric such as cash flow, EBITDA, EBIT, or Revenue in the final forecast year. The formula for the Exit Multiple method is:

\(TV = Multiple \times Financial \, Metric \)

Where:

\(Multiple\) = Market-derived exit multiple (e.g., from comparable companies).

\(Financial \, Metric\) = cash flow, EBITDA, EBIT, or Revenue in the final forecast year.

The Exit Multiple Model for calculating Terminal Value faces several challenges that can impact the accuracy of your valuation. One such issue is the difficulty in selecting an appropriate multiple. This is because market conditions change and industry comparables vary widely over time.

Additionally, the model assumes that the business will be sold at the end of the projection period at this multiple. However, this may not reflect actual future market realities or the company’s unique circumstances. The reliance on historical multiples can lead to valuation distortions if they do not match what happens years down the road. Furthermore, the Exit Multiple method ignores the underlying drivers of value such as earnings growth.

Example:

Let’s take the same company as above, but this time, we will use the Exit Multiple Model:

EBITDA (Year 5): $120 million

Exit Multiple: 10x (based on comparable company analysis)

The Terminal Value calculation then yields:

\(TV = 10 \times 120 = 1200 million \)

In this case, the Terminal Value using the Exit Multiple Model is $1.2 billion.

Key Differences Between the Terminal Value Models

Perpetuity Growth Model: Relies on assumptions about perpetual growth in free cash flow, and therefore, requires careful judgment regarding the long-term growth rate and discount rate.

Exit Multiple Model: Uses market-based multiples, which can be more reflective of current market conditions and trends, but it assumes that the company can exit at an appropriate multiple.

The Takeaway

Both the Perpetuity Growth Model and the Exit Multiple Model offer you valuable methods for estimating the Terminal Value in a DCF analysis. The choice between the two largely depends on the nature of the company being valued and the availability of market data. The Perpetuity Growth Model is often used for businesses with predictable long-term growth, while the Exit Multiple Model is preferred when there are reliable comparables available.

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