Definition: Terminal value is the sum of all cash flows from an investment or project beyond a forecast period based on a specified rate of return. In other words, it’s the estimated value of an asset at maturity adjusted for interest rates and cash flows in today’s dollars. This is important for the calculation of the expected future cash flows using the dividend cash flow valuation model.
What Does Terminal Value Mean?
The TV determines the value of a project at some future date when exact future cash flows cannot be estimated. Although there are various ways to calculate the terminal value, the most popular approach is the Gordon Growth Model. The GGM assumes that a company will continue to generate a stable growth forever and values a project in perpetuity. The model also assumes that the cash flows of the last projected year are stable and discounts them at weighted average cost of capital to find the present value of the expected future cash flows.
To calculate this ratio using the GGM, we need to know:
- FCFF = free cash flow in the final year
- g = perpetuity growth
- WACC = discount rate
Therefore, the terminal value formula is calculated like this
TV = FCFF x ( 1 + g ) / ( WACC – g )
Let’s look at an example.
Mary Ann is a financial analyst at Goldman Sachs and she is asked to value a project using the Gordon Growth model. The project’s cash flows are expected to grow in perpetuity by 2% annually. Mary Ann estimates that the free cash flow in Year 6 will be $20.5 million. She also calculates a discount rate of 11%.
By plugging the numbers into the formula, Mary Ann finds that the TV of the project is:
FCFF x ( 1 + g ) / ( WACC – g ) = $20.5 x ( 1 + 0.02 ) / ( 0.11 – 0.02 ) = $20.5 x 1.02 / 0.09 = $232.3 million.
Thus, Mary Ann calculates that the project is worth $232.3M today.
Note: the stable growth rate should be equal to or lower than the growth rate of the economy in which the firm operates – in this case, 2% which the estimated long-term growth of the U.S. economy.