Terminal value, or TV for short, refers to an asset, business, or project’s value beyond a forecasted period. TV assumes an asset will continue growing at a predetermined growth rate in perpetuity once the forecast period is over. The process of how to calculate terminal value can be done in a few different ways, including discounted cash flow and the perpetuity method.
What is the terminal value?
- Discounted cash flow (DCF). The DCF approach is often used in corporate acquisitions. It is built on the foundation that an asset’s value = its future cash flows.
What does the discounted portion mean? It refers to the fact that cash flows have to be discounted to the present value when using the approach because of external factors, like interest rates.
- Perpetuity method. The perpetuity method assumes the growth rate of free cash flows in the last year of the initial forecast period will continue forever.
The formula for calculating terminal value is:
(FCF * (1 + g)) / (d – g)
To use the formula to estimate an asset’s terminal value, divide the last cash flow forecast (FCF) by:
- The difference between the discount rate (d).
- The terminal growth rate (g).
Terminal growth rates generally range between the inflation rate and average GDP growth rate.
Terminal value case study
Jason is investing in a new condominium in his hometown. He just turned 30 and has plenty of time for the investment to grow. While he’s gone over the terms of the investment and the provided literature on how much it’s expected to grow in the forecast period, with time on his side, he wants to make sure the investment will still be worth it in 35+ years because whatever he invests in, he plans to pass on to his children. Jason uses the perpetuity method to calculate his ROI way into the future and is pleased with what the estimates say. So, he signs on the dotted line and begins his real estate investing career.
Jason purchases the condo for $350,000, with the expectation that he can sell it for $750,000 in 25 years. To calculate, he takes the discount rate (10%) and the future cash flow ($750,000) from the future sale of the condo, which confirms that he will profit $400,000 on the condo in 25 years.
The bottom line
So, what is the terminal value in a nutshell? For many smart investors, knowing an asset’s value throughout the course of the projected term is not enough. They want to know how it’s predicted to perform well down the line. Investors turn to the terminal value when looking for additional ways to research the future performance of an investment, helping them make informed decisions on what to invest in. This can be used for a number of investments, including the stock market and real estate.