Unfortunately, in business, there are no crystal balls. However, business owners will be used to taking the financial data that’s in front of them and using it to inform their cash flow forecasts for the weeks and months ahead. But is there a business tool or formula that allows you to see even longer-term projections?
Terminal value gives business owners a way to effectively understand what their business might be worth several years into the future, usually around five to 10, beyond the scope of cash flow forecasts.
For Rav Panesar, Founder of the online diary app and social enterprise Rymindr, calculating terminal value supports him in making more informed decisions around his company's long-term growth strategy.
Let’s take a closer look at what terminal value means, why it’s worth calculating and the decisions it can help you make as a business owner.
What is terminal value?
Terminal value is the value of an asset, company, or project at a future point in time. Specifically, it estimates how much a business may be worth beyond its cash flow forecasts, and assumes the company will reach a stable and constant growth rate indefinitely, beyond this period.
Why calculate terminal value?
Terminal value helps business owners to make important strategic decisions, like whether to invest in a new project or look to raise money.
For Panesar, terminal value helped him understand the intrinsic value of his business, which in turn supported a decision as to whether or not to seek outside investment, such as from venture capitalists.
How to calculate terminal value
Perpetuity growth formula
The perpetuity growth formula assumes that your company’s free cash flow grows at a constant or fixed rate indefinitely after the initial forecast period. For example, if you initially calculated cash flow forecasts five years into the future, from this point you would then estimate terminal value.
Let’s take a closer look at the perpetuity growth formula and its main components.
Terminal Value = (FCFn x (1 + g)) / (WACC – g)
FCF: Free cash flow
Free cash flow is the money your business makes every year after deducting its outflows, such as operating costs, investments and financing activities. In other words, it is the money a company can use as it chooses, such as to reinvest or distribute to shareholders.
WACC: Weighted average cost of capital
WACC is the rate at which a company’s future cash flow needs to be discounted to arrive at a present value for the business. It considers the costs of debt and the cost of equity, then adds a weighting in proportion to the amount in which each is held.
n: Year-1 of terminal value period
This is the first year of the terminal value period or the first year for which you are calculating terminal value.
g: Perpetual growth rate of FCF
This is the estimated long-term growth rate of the business beyond the forecasted period. It is typically in line with the long-term inflation rate and no higher than the historical gross domestic product rate (GDP). Panesar says he based his growth rate assumption on the expected growth rate of the overall market, the competitive landscape and Rymindr’s growth potential.
Exit multiple formula
This calculation assumes the company is sold for a multiple of an income or cash flow measure, such as sales, profits or earnings before interest and tax (EBIT). It then considers that the company will be valued at the end of the forecast period, based on public market valuations of similar companies that were recently sold. The exit multiple formula is:
Terminal Value = Financial Metric (e.g. EBIT) x Trading Multiple (e.g. 10x)
Terminal value example
Let’s take the perpetuity growth model and run through an example of how to calculate terminal value.
Terminal Value = (FCFn x (1 + g)) / (WACC – g)
FCF: £10,000
WACC: 10%
g: 4%
The cash flow at the end of the initial forecast period is £10,000; the WACC has been calculated as 10% and the perpetuity growth rate is 4%. To calculate terminal value:
Terminal Value: ([£10,000 x (1 + 4.0%)] / [10.0% - 4.0%]) = £173,333
This means that the valuation of the company, assuming constant growth in cash flow after the forecast period of 4%, is £173,333.
Negative terminal value
While rare, it is possible to show a negative terminal value. This means that the cost of future capital is higher than the assumed growth rate of the company. In other words, future cash outflows are exceeding the predicted growth rate.
Advantages of calculating terminal value
Firstly, terminal value helps a business gain a better understanding of whether they are at financial risk based on projections, leading to more informed decision-making in the present. Once you've made certain financial adjustments, you can then run the numbers again using terminal value to evaluate what's been successful, and what hasn't.
What's more, as well as cash flow projections, potential investors may wish to see your terminal value so they have more of an overview of potential longer-term growth.
Disadvantages of calculating terminal value
Terminal value calculations are based on future predictions and assumptions, which means it is impossible to be completely accurate. For example, the perpetuity growth model assumes a company will grow at the same rate indefinitely into the future. It doesn't consider that over time, economic and market conditions will likely change this growth rate. And in the same way, the exit multiple formulae uses multiples that again will change over time.
Panesar recognises these limitations. "It can be quite challenging to calculate the terminal value of a technology business due to the rapid pace of technological innovation and changing market conditions," he says. "Over the last two years, there have been huge changes which have meant the growth potential for Rymindr has exploded, which directly impacted our objectives." To account for this, Panesar not only calculated terminal value in the first year of business, but repeated the calculation again three years later.
Despite certain limitations, calculating terminal value is an effective way to better understand the future value of your business, so that you can make data-led decisions for growth in the here and now. But the more volatile your cash flow, the harder it becomes to calculate the terminal value of your business - especially when you’re forecasting that far in the future.
Fortunately, with payment terms of up to 54 days, the American Express® Business Gold Card helps put more flexibility in your cash flow, helping you gain more control of your cash flow¹.
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