Definition of Terminal Value
The cash flow for a firm is projected for several years. In a discounted cash flow valuation, after which reasonable accuracy of annual cash flows forecast is not possible. In such case, instead of forecasting varying cash flows, a single value representing the discounted value of a subsequent cash flow is used which is referred to as terminal value.
Explanation of Terminal Value
One approach to calculation of terminal value assumes that the project generates a perpetual uniform stream of cash flows beyond time “t”. Under this approach, present value of perpetuity formula is used to calculate the terminal value:
|Terminal Value =||Annual Cash Flow Beyond Time “t”|
|Required Return − Growth Rate|
Another approach uses relative valuation. Under this second approach, terminal value equals some multiple of its sales, EBIT, EBITDA, or free cash flow, etc. The benchmark multiples are based on the company’s industry and competitors. For example, the terminal value of a company in 30 years can be estimated as the product of that company EBITDA and EV/EBITDA ratio of PepsiCo or average EV/EBITDA for the industry.