In simple terms terminal value is value of an asset at the end of its useful life. The current or present value of an asset is the terminal value discounted as its cost of capital (interest). It is imported to know the terminal value of the item before we ended its run, because if we were not making profit, it would be pointless.
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. Since, we cannot estimate the cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period.
The terminal value is also called as horizon value or continuing value. Terminal value is an important input in the multi-stage discounted cash flow models. Discounted cash flow models project cash flows into future and then discount those to find the present value of the security or the project.
The terminal Value (TV) is used hand-in-hand with the discounted cash flow analysis to assess the present value of a firm. The discounted cash flow analysis calculates the value of a firm for several years – typically 3-5 – based on projected cash flow for the firm during that period.
The terminal value calculation is used to determine the value of the firm for all years beyond which one can reliably project cash flow using discounted cash flow.
The terminal value can be estimated using the following methods:
- Liquidation value method
- Multiple Approach method
- Stable Growth Model
Liquidation value model is most useful when assets are separable and marketable. Multiple Approach method is easiest approach but makes the valuation a relative valuation. Stable Growth Model is Technically soundest, but requires that you make judgments about when the firm will grow at a stable rate which it can sustain forever, and the excess returns (if any) that it will earn during the period.
