How Is Terminal Value Discounted?

Most fundamental investors are familiar with the discounted cash flow model. This is where the value of a company's cash flows is projected over a period of time, where the standard is three to five years, and discounted based on the time value of money.

Terminal value does something similar, except that it focuses on assumed cash flows for all of the years beyond the limit of the discounted cash flow model. An asset's terminal value is typically added to future cash flow projections and discounted to the present day. Discounting is performed because the terminal value is used to link the money value between two different points in time.

There are several terminal value formulas. Like discounted cash flow analysis, most terminal value formulas project future cash flows to return the present value of a future asset. The exception to this is the multiples approach. This article looks at the discount terminal value and some of the methods used to estimate it.

Why Discount Terminal Value?

The value of a business, asset, or project past the point of a forecasted period is referred to as its terminal value. This is the point at which future cash flows can be estimated.

Most companies do not assume they will stop operations after a few years. They expect business will continue forever (or at least for a very long time). As such, the terminal value is an attempt to anticipate a company's future value and apply it to present prices.

Remember, the value of money does not stay constant over time, so it doesn't do today's investors any good to only understand the nominal value of a company many years into the future. This can only be done by discounting future value.

How to Discount for Terminal Value

Suppose an investor used a discounted cash flow formula to find the present value of an asset five years into the future. The same investor could use the terminal value to estimate the present value based on all cash flows after the fifth year into the discounted cash flow model.

All future earnings need to be discounted. Since the terminal cash flow has an undefined horizon, calculating exactly how to project a discounted cash flow can be challenging. There are three primary methods for estimating the terminal value. These are the liquidation value model, the multiple approach, and the stable growth model. We've highlighted some of the key characteristics of each below.

1. Liquidation Value Model

The first method is known as the liquidation value model. This approach is used under the assumption that the business won't be operational at a given point in the future. Given this fact, the company expects it will have to sell off its assets before ceasing operations. One thing to keep in mind is that this doesn't include any intangible assets like trademarks and intellectual property.

The liquidation value model requires figuring out the earning power of a business's asset(s) with an appropriate discount rate. This rate is then adjusted for the estimated value of outstanding debt.

2. Multiples Approach

The multiples approach works under the assumption that similar assets will sell at similar prices. This model is also called the exit multiple method.

This method uses the approximate sales revenues of a company during the last year of a discounted cash flow model and then uses a multiple of that figure to arrive at the terminal value. Some of the most common multiples used in this method include the enterprise value to the earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) ratio, and the enterprise value to earnings before interest and taxes (EV/EBIT) ratio.

For example, a company with a projected $200 million in sales and a multiple of 3 would have a value of $600 million in the terminal year. There is no discounting in this version.

3. Stable Growth Model

The last method is the stable growth model. Unlike the liquidation values model, stable growth does not assume the company will be liquidated after the terminal year. Instead, it assumes that cash flows are reinvested and that the firm can grow at a constant rate into perpetuity.

The discount rate for this model is different depending on whether it's applied to an equity or a company. The cash flow for an equity is treated like dividends in the dividend discount model. For a company, the discount rate is more similar to discounted cash flows.

The Bottom Line

The value of an asset that reaches the end of its useful life is called its terminal value. Discounting this value is important because the value of money today won't be the same tomorrow. Put simply, one dollar won't buy nearly as much in the future as it does today. So why would you discount terminal value? It's to help provide estimates on the future value of a business, asset, or project by putting it into today's prices.