How do you calculate terminal value?

Enterprise value is the value of the business, which is calculated as the total present value of free cash flows the company would obtain throughout its lifetime. Since we can only project cash flows reasonably for a limited number of years, usually 5-10 years, we have to calculate the value of the company after this projection period. This value is known as terminal value.

Implied enterprise value = present value of the projected cash flows + present value of terminal value

There are two ways to calculate terminal value:

  • EBITDA Multiples Method: the median EBITDA multiple the market would pay for your company once it reaches a stage of maturity, based on mature comparable companies in the same industry
    • Terminal value = median EBITDA multiple of mature comparable companies x final projected EBITDA (typically year 5 or 10)
    • We find the median EBITDA multiple of mature comparables because the target company will likely become mature at the end of its projection period
  • Perpetuity Growth Rate Method: growth rate at which your company‚Äôs unlevered free cash flows would increase on an annual basis once it has become mature (after projection period)
    • Terminal value = (Final Projected Year UFCF x
      (1 – Perpetuity Growth Rate)) / (WACC – Perpetuity Growth Rate)
    • Growth rate is typically 2 – 3% as that is in-line with annual GDP growth
    • The perpetuity rate should never be higher than the GDP growth rate, or else the company would grow to be bigger than the economy one day