In commercial real estate financing, many of your accounting formulas and leverage ratios will be based on estimations. Terminal value (TV) is one of those educated guesses that you can easily calculate to get a better perspective on your potential investments. Like imputed equity, terminal value measures the future worth of your investment based on real figures, but isn’t completely reliable.
What Is Terminal Value (TV)?
Terminal value (TV) measures the value of an asset beyond when future cash flows can be predicted. After the forecast period, a set growth rate is assumed.
The further away a price is from being estimated, the less reliable the terminal value becomes. Analysts will use financial models to counter this issue.
One method is discounted cash flow (DCF), which is often used in corporate acquisitions. DCF is built on the theory that an asset’s value is equal to its future cash flows. The method is called ‘discounted’ cash flow because the cash flows must be discounted to the present value, due to factors such as interest rates.
Discounted cash flow will help forecast a period of up to five years before predictions become unreliable. This is when terminal value must be used. The most common methods of terminal value are the perpetuity method and the exit multiple method.
If the terminal value is a negative, this means that the growth rate does not exceed the cost of future capital. This is fairly rare and, often, wouldn’t remain negative for very long.
If investors want to estimate the terminal value for an asset that has an infinite window of operations, the perpetuity method is the best choice.
Within a distinct period, a business’ valuation can be fairly accurately projected. The further into the future this period goes however, the less reliable the projection is.
Therefore, investors assume that cash flows will grow at a stable rate infinitely in the future. This is the terminal value.
The formula to calculate terminal value is as follows:
(FCF * (1 + g)) / (d – g)
Dividing the last cash flow forecast (FCF) by the difference between discount rate (d) and terminal growth rate (g), will estimate the valuation of an asset after the forecast period.
This will produce a consistent terminal growth rate that the company is predicted to grow at forever. This rate starts at the end of the last forecasted cash flow period (FCF) using the discounted cash flow model then into the perpetuity method.
Terminal growth rate results will often be in line with inflation rates but lower than the GDP growth rate.
Exit Multiple Method
If a finite window of operations is assumed, the exit multiple method is a better fit. This could be due to the asset being sold after a certain period. The value of acquisitions are mostly calculated using the exit multiple method.
In this method, the terminal value will reflect the net realizable value of a company’s assets at the end of the window of operations.
The equation for terminal exit multiple is as follows:
Final year of projected EBITDA x Industry exit multiple
The final year of projected EBITDA can also be swapped out for the final year of projected revenue. The industry exit multiple is the average multiple at the point of sale.