In a discounted cash flow valuation, the cash flow is projected for each year into thefuture for a certain number of years, after which unique annual cash flows cannot beforecasted with reasonable accuracy. At that point, rather than attempting to forecastthe varying cash flow for each individual year, one uses a single value representing thediscounted value of all subsequent cash flows. This single value is referred to as the
The terminal value can represent a large portion of the valuation. The terminal value of a piece of manufacturing equipment at the end of its useful life is its salvage value,typically less than 10% of the present value. In contrast, the terminal value associatedwith a business often is more than 50% of the total present value. For this reason, theterminal value calculation often is critical in performing a valuation. The terminal valuecan be calculated either based on the value if liquidated or based on the value of thefirm as an ongoing concern.
Terminal Value if Liquidated
If the firm is to be liquidated, the liquidation value can be based on book value, salvagevalue, or break-up value, but liquidation value usually understates the terminal value of a healthy business. One must make assumptions about the salvage value of the assetsand net working capital. The net working capital may have a certain recovery rate sinceit might not be readily liquidated at balance sheet values. In the pro forma projections,one often may assume that net working capital will grow at the same rate as cash flow.The terminal value if the firm is liquidated then is the sum of the discounted value of thecash flow, the recovered net working capital, and the salvage value of the long-termassets, including any tax benefits.
Terminal Value of the Ongoing Firm
For an ongoing firm, the terminal value may be determined by either using discountedcash flow (DCF) estimates or by using multiples from comparable firms.For the DCF method, if the unlevered free cash flow is growing at a rate of
per year for a set number of years, the terminal value can be calculated by modeling the cashflow as a T-year growing perpetuity. At the end of T years, one can assume a differentgrowth rate (possibly zero) or liquidation. If multiples from comparable firms are used,the price/earnings ratio, market/book values, or cash flow multiples are commonly used.