The biggest challenge in valuing a business is to estimate its future worth. Financial models can forecast cash flows for a few years, but beyond that, predictions start losing accuracy. Markets evolve, consumer behaviour shifts, new competitors rise, and global events can reshape entire industries. In such an uncertain world, how do we assign value to a business that is expected to continue operating well into the future?
That’s where Terminal Value (TV) comes in. Terminal value is the concept that allows us to capture the worth of a company beyond the forecast period—usually three to five years. It assumes the business won’t just stop after this period but will continue generating cash flows for a long time. In fact, in most valuation models, terminal value often contributes the largest portion of the company’s overall value.
Why Is Terminal Value Needed?
When analysts build financial models, they break a company’s value into two parts:
While the first part can be projected with some reliability, the second part is almost impossible to forecast year by year. Terminal value acts as a shortcut. It bundles all those future cash flows into one number, making it possible to estimate the company’s long-term worth. Without it, valuations would be incomplete.
How to Calculate Terminal Value?
There isn’t one fixed formula for terminal value. Instead, analysts use two popular methods, depending on the situation:
1. Perpetual Growth Method (Gordon Growth Model)
This method assumes that the company will keep generating free cash flows at a steady, constant growth rate forever. It’s a practical way of saying: “This business won’t grow at crazy rates forever, but it will continue to grow steadily, like the economy itself.”
The formula is:
TV = FCF / (d – g)
Where:
Example: If free cash flow in the last forecast year is ₹100 crore, the discount rate is 10%, and growth rate is 3%, then:
TV = 100 / (0.10 – 0.03) = ₹1,428.6 crore
This means that at the end of the forecast period, the company is estimated to be worth around ₹1,428.6 crore.
2. Exit Multiple Method
The second method looks at how companies are bought and sold in the real world. Instead of assuming infinite growth, it assumes the company will eventually be sold at a price based on market multiples such as P/E ratio or EV/EBITDA.
Formula:
TV = Financial Metric × Multiple
Example: If the company’s EBITDA in the last forecast year is ₹200 crore and the industry average multiple is 8×, then:
TV = 200 × 8 = ₹1,600 crore
This approach is often favoured by investment bankers and private equity firms because it reflects actual market practices.
Terminal Value (TV) vs. Net Present Value (NPV)
It’s easy to confuse terminal value with net present value, but they are not the same.
In short, terminal value is a building block inside the NPV framework.
The Importance of Assumptions
One of the biggest things to remember about terminal value is that it’s highly sensitive to assumptions. A small change in the discount rate or growth rate can completely change the outcome. For instance, moving the growth rate from 3% to 4% might add billions to the valuation.
Because of this, professionals often calculate terminal value using both methods the perpetual growth model and the exit multiple approach and then take an average. This helps reduce the risk of being overly optimistic or too conservative.
Can Terminal Value Be Negative?
In theory, yes. If the discount rate is much higher than the growth rate, terminal value could turn negative. This would mean the business’s cost of capital outweighs its growth prospects, signaling very poor financial health. In practice, companies don’t have “negative” terminal values for long. At worst, equity value can fall to zero in cases like bankruptcy, but the business still has some realizable assets.
Key Points to Remember
The Bottom Line
No one can predict the distant future of a company with certainty. But investors and analysts still need a framework to capture the long-term worth of businesses. Terminal value provides that framework. It simplifies the complex, infinite stream of future cash flows into a single number that can be discounted to today.
Whether through the steady-growth approach of the Gordon Growth Model or the market-based logic of the Exit Multiple Method, terminal value is central to valuation. While it may not deliver a perfect answer, it ensures that our analysis doesn’t stop at five years—it carries forward the reality that businesses are built to endure.
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