Under the discounted cash flow method, the value of a business is derived from a series of projected annual cash flows. At the end of the discount period, cash flow is expected to stabilize — or the business is presumed to be sold or liquidated. This final part of the analysis is critical, but can be confusing.
Demystifying terminal value
The International Glossary of Business Valuation Terms defines terminal (or residual) value as “the value as of the end of the discrete projection period in a discounted future earnings model.” Terminal value is discounted to present value. Then it’s added to the net present value of annual cash flows over the discrete projection period to arrive at the value of the business under the discounted cash flow method.
Business valuation experts typically consider the capitalization of earnings method and the market approach when estimating terminal value. Either (or both) may be appropriate, depending on the nature of the business, purpose of the valuation, reliability of the company’s financial projections and availability of market data.
The capitalization of earnings method is based on the assumption that cash flow will stabilize in the final year of the projection period. However, this is also the time period that’s subject to the greatest margin for error because it’s the furthest into the future.
Under the capitalization of earnings method, terminal value equals expected future cash flow (the numerator) divided by a capitalization rate (the denominator). Long-term growth is used in the numerator to determine cash flow in the final projection period. Then it’s used again in the denominator, because the capitalization rate equals the discount rate minus the long-term sustainable growth rate.
Because it’s in both the numerator and the denominator, the long-term sustainable growth rate can have a significant impact on terminal value. A minor change in the long-term growth rate can have a major impact on business value.
Applying the market approach
Another way to estimate terminal value is to assume that the business could be sold at the end of the discrete period in an arm’s length transaction. Using the market approach, a business valuation expert considers comparable public stock prices and sales of comparable private businesses. Although the market approach sounds straightforward, it can sometimes be difficult to find comparable transactions, especially for small private firms.
Comparable market data also might serve as a sanity check. For example, a valuation expert might compare 1) the implied pricing multiples from a terminal value that’s been calculated using the capitalization of earnings method, and 2) average pricing multiples from comparable transactions involving similar companies in recent years.
There may be cause for concern if, say, a company’s terminal value generates a price-to-revenues multiple of 5.0 and comparable transactions during the last 12 months indicate an average price-to-revenues multiple of 0.9. The expert would need to explain the reason for such a discrepancy — or adjust his or her analysis.
Terminal value can be a major part of the valuation puzzle, so it’s important to get it right. Contact a business valuation professional to develop a terminal value that’s based on reliable projections and objective market data.