Terminal Value: The Key to Valuing a Business

Let’s start with a simple example:
Imagine you have a lemonade stand, and it’s doing really well. You’re making money every year, and you expect that you’ll keep making money for a long time. But what if someone wanted to buy your lemonade stand? How do they figure out how much your business is worth, especially since it will keep making money even after 10 or 20 years?

That’s where Terminal Value comes in. It’s like putting a price tag on all the money your lemonade stand will make far into the future—after you’ve already counted the money from the first few years.

What is Terminal Value?
When businesses grow, they often plan for the money they’ll make in the next 5 or 10 years. But businesses don’t stop making money after 10 years—they aim to last much longer! Terminal Value is a way to calculate how much a business is worth after that initial period (often called the projection period).

In simple terms, Terminal Value (TV) captures the value of a company’s future cash flows beyond the years we can easily predict. It’s a key part of figuring out how much a business is worth today.


Why is Terminal Value Important?
1. Businesses Are Built for the Long Run
Most companies don’t have an “end date.” Terminal Value accounts for the idea that a business will keep making money in the far-off future.

2. Efficiency in Valuation
Instead of guessing cash flows for every single year forever, we use Terminal Value as a shortcut. It saves time and simplifies the process.

3. Big Part of Valuation
For most businesses, Terminal Value makes up a significant chunk of their total valuation, especially if they plan to grow steadily over the years.

How is Terminal Value Calculated?

There are two main ways to calculate Terminal Value:

1️⃣ The Perpetuity Growth Model
This method assumes the company will grow forever at a steady, small rate. Here’s the formula:

Terminal Value = {Final Year Cash Flow*(1 + g)}/(r*g)

• g = Growth rate of cash flows (e.g., 2–3%)

• r = Discount rate or required rate of return (e.g., 10%)

Example:
If your lemonade stand earns $10 in Year 10 and you expect it to grow 2% every year, and the discount rate is 10%, the Terminal Value would be:

TV = (1 + 0.02)}{0.10 – 0.02} = {10.2}{0.08} = 127.5

This means someone might pay $127.50 for your lemonade stand’s future earnings.

2️⃣ The Exit Multiple Method
This approach uses how similar businesses are valued, based on a multiple of their earnings or cash flows. For example:

TV = Final Year EBITDA * Industry Multiple

If lemonade stands in your area are sold for 12 times their yearly profit, and your stand earns $10, the Terminal Value would be:

TV = 10*12 = 120

When Do We Use Terminal Value?
Terminal Value is part of the Discounted Cash Flow (DCF) method, which helps investors and analysts figure out how much a business is worth. In a DCF, you:

1. Predict the company’s cash flows for a few years.
2. Estimate the Terminal Value.
3. Discount everything back to today’s value.

Challenges of Terminal Value
While Terminal Value is super helpful, it’s not perfect. Here are some things to keep in mind:

• Guesswork: The growth rate (g) and discount rate (r) can be tricky to estimate.

• Over-reliance: Sometimes, Terminal Value ends up being a big part of the total valuation, which can skew results.

Final Thoughts
Terminal Value is like looking at the horizon of a company’s future. It captures the idea that businesses don’t just stop after a few years—they keep running, innovating, and earning. Whether you’re valuing a lemonade stand or a big corporation, Terminal Value helps paint a clearer picture of a company’s worth in the long run.

Thought Starter: When you look at your favorite company, do you think they’ll still be around in 10, 20, or 50 years? How might their Terminal Value look today? 🌟