Key Takeaways
- Companies often use terminal value to gauge financial performance far into the future to set growth strategies and lure investors.
- In some cases, terminal value can also be employed to help with decision-making in portfolio-diversifying alternative investments such as commercial real estate.
- Despite the benefits of terminal value, it can still be challenging to project an accurate rate of growth due to assumed formulaic values.
Since companies often use terminal value (TV) to assess financial performance far into the future, they can use the financial metric to set growth strategies. They also employ it to entice potential investors. But what is terminal value? Here is that and more.
What is Terminal Value?
It gets harder to forecast as the time horizon becomes ever longer. This is true when it comes to making an “educated guess” about what a company’s cash flows will be well into the future.
Enter terminal value, which essentially is an investment’s value beyond an initial forecast period. It captures values that are otherwise hard to predict when employing the traditional financial model forecast period.
In other words, terminal value is the value of a project, business, or asset beyond the forecasted period when there can be future cash flow estimations. Terminal value, which often comprises a substantial portion of the total assessed value, assumes a business will forever grow at an established rate following the forecast period – usually three to five years.
How to Calculate Terminal Value
There are a few ways to calculate terminal value, including by using the perpetuity growth and exit multiple models.
The perpetuity growth method assumes that an enterprise will produce cash flows forever at a constant rate. The formula here is [FCF x (1+g)]/(d-g), where:
- FCF = cash flow for the last forecast period
- g = terminal growth rate
- d = discount rate, which is usually capital’s weighted average cost.
The terminal growth rate is the constant rate at which a company is expected to grow forever – into perpetuity. The growth rate begins at the conclusion of the most recent forecasted cash flow period in a discounted cash flow model and continues on an infinite basis. Usually, the terminal growth rate is aligned with the long-term inflation rate but will not surpass the historical gross domestic product.
Then there is the exit multiple method, which assumes that a business will ultimately be sold. In other words, if investors assume that a company’s operations are finite, a perpetuity growth model is unnecessary. Rather, the terminal value mirrors what a company’s net realizable value is at the time.
The formula here is the most recent metric, such as sales or profits, multiplied by the multiple that is decided upon, which is typically an average of other transactions’ recent exit multiples.
There are also alternative TV methods such as liquidation value and replacement value. The former, which refers to a company’s worth when its assets are sold, is the most conservative valuation approach. Meanwhile, replacement value is how much a company or other entity would have to pay to supplant an asset presently, based on its current worth.
Which Method Should Be Used When Calculating Terminal Value?
It is important to note that neither the perpetuity growth approach nor the exit multiple model will likely yield a 100 percent accurate terminal value estimate. Determining which method to employ will hinge in part on whether an investor seeks to garner a comparatively more sanguine or conservative estimate.
In general, estimating terminal value by using the perpetuity growth model yields a relatively higher value. Ultimately, investors may wish to use both terminal value calculations, then employ an average of the two to reach a final estimate for net present value.
What are Some Challenges and Limitations of Calculating Terminal Value?
It can be challenging to project an accurate rate of growth, and any assumed formulaic values can result in calculation inaccuracies. Because terminal multiples are dynamic, they naturally change over time.
The perpetuity growth rate assumes a continuation of free cash flow growth at a constant pace into perpetuity. Such an assumption is not always accurate. The model also lacks the market-driven analytics used in the exit multiple approach. Also, the latter approach, at a given discount rate, implies a terminal growth rate, and any terminal growth rate implies an exit multiple.
Thus, it may be advisable to employ a broad range of multiples and applicable rates to ensure an acceptable and realistic result.
When is Terminal Value Applicable?
Terminal value is most often used in discounted cash flow (DCF) analyses, to set company valuations, and for investment decision making.
DCF analysis is a method employed to value an asset, company, or project that incorporates the time value of money. In such an analysis, the terminal value is configured in accordance with projected future free cash flows. The terminal value as well as the forecast periods are essential components of discounted cash flow.
Meanwhile, the perpetuity model and exit multiple approach are used for whole-company valuation purposes.
While not all investors need to assess terminal value, the metric is applicable to investment strategies. Investors can estimate a value over the period for which they can accurately assess cash flows, then employ a more generalized approach to estimate the remaining value, which is the terminal value.
To arrive at an estimated value for the selected period, the investor can use a valuation technique such as the discounted cash flow model. Then, the investor can estimate the terminal value at that period’s end. The investment’s total value would be the combined value of the two estimations.
Can Terminal Value Inform Alternative Investment Decision Making?
Individual investors can use TV to estimate their investment’s value beyond the period for which they are confident they can garner a valid forecast.
The metric can also be used to inform decision-making regarding alternative investments such as those offered by the leading alternative investment platform Yieldstreet. Alternative investments are essentially any assets other than stocks, bonds, and cash.
In the context of commercial real estate, for example, an investment property’s TV can be estimated by applying a terminal cap rate to its projected net operating income on the property’s sale date or the year after.
While a property that generates income can theoretically continue to do so indefinitely, most investors will ultimately seek a return of principal. That is where terminal value comes in.
In addition to generating steady secondary income, alternative investments such as real estate can serve to diversify investment portfolios, which, in turn, can mitigate overall risk. Diversification is an essential part of long-term investment success.
Alternative Investments and Portfolio Diversification
Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.
In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.
To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.
Summary
As a financial metric, terminal value can show investors what the future value of their investment in an enterprise or project will likely look like. It can also be employed to help with decision-making in portfolio-diversifying alternative investments such as commercial real estate.
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2 Represents an net annualized return, using an internal rate of return (IRR) methodology, with respect to the matured investments shown in your Portfolio experience, utilizing the effective dates and amounts of subscriptions and distributions to and from the investments, net of management fees and all other expenses charged to the investments.[read more]