The terminal value (TV) is used hand-in-hand with the discounted cash flow analysis to assess the present value of a firm. The discounted cash flow analysis calculates the value of a firm for several years -- typically 3-5 -- based on projected cash flow for the firm during that period. The terminal value calculation is used to determine the value of the firm for all years beyond which one can reliably project cash flow using the discounted cash flow.
The terminal value can be calculated in several ways. One calculation assumes the liquidation of the firm's assets in the final year of the discounted cash flow analysis. This method estimates what the market would pay for the firm's assets at this point. The other two methods assume the firm will continue operations for an indefinite time period. The terminal value is determined either by applying a multiple to earnings, revenues or book value or by assuming an indefinite, constant growth rate.
By assuming a firm will cease operations and liquidate its assets at the end of the discounted cash flow analysis, you can simply calculate the value of the firm's existing assets and adjust for inflation as following. However, this approach is limited as it doesn't reflect the earning power of the firm's assets.
The perpetual growth valuation assumes that the company will grow at a constant rate forever. To calculate this, use the formula
Cash Flow t+1 represents the first year beyond the discounted cash flow analysis, r is the interest rate and g is the stable growth rate. If the company is assumed to disappear at some point in the future, a negative growth rate can be used.
When applied to the discounted cash flow, the terminal value should be discounted by dividing the terminal value by (1 + r)^t.
With the multiple approach, the value of the firm is estimated by applying a multiple to the firm's earnings or revenues. For example, one might multiply an appropriate industry price to earnings ratio to the estimated earnings in order to arrive at a terminal value for the firm.
Unfortunately, this simple method can produce somewhat unreliable results. For example, if one uses a multiple based on comparable firms in today's markets, that multiple hasn't been discounted to account for the value several years from now at the point of the terminal value calculation. Given the complications this presents, it is best to use the Stable / Perpetual Growth calculation.
As with any forecast or prediction, the further out it is, the greater the chance of error. Keep in mind that terminal value is typically forecasted for some X periods into the future, for an indefinite amount of time beyond. A number of assumptions must hold true to obtain even a modestly accurate terminal value.
Because of this, many analysts may opt to instead use a 'base case' terminal value, with as conservative assumptions as possible - while this has the potential benefit of limiting downside and maximizing upside, it does not necessarily imply accuracy (which is typically how the greatest returns are generated).
All this goes to say is that while terminal value is a useful and sometimes necessary metric for valuation, it should be subject to significant scrutiny, as even small changes in the underlying assumptions can have meaningful overall impact.
In finance, the terminal value (continuing value or horizon value) of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years. Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. The terminal value is calculated in accordance with a stream of projected future free cash flows in discounted cash flow analysis. For whole-company valuation purposes, there are two methodologies used to calculate the Terminal Value.