A successful business is worth more than the value of its assets. One way to set a price on a company is to estimate its discounted cash flow (DCF). First, you estimate how much cash the company will generate in the coming years. Then you discount the future cash flow to set the value in the present. The terminal value formula helps you calculate the DCF.
TL;DR (Too Long; Didn't Read)
Terminal value is the worth of a company at a point in the future, for example, five years from now. The simplest terminal value formula is to calculate the future value of a metric such as earnings and multiply that to get terminal value. The multiplier varies according to the industry the company is in.
Learn the Terminal Value Definition
Even if you're confident the company will stay in business for 50 years, you can't measure cash flow that far out. Predictions that far ahead are so unreliable you're not calculating cash flow, you're guessing it. Terminal value takes care of that. You set a forecast of three to five years – with some businesses you can go further out – and calculate the company's terminal value at the end of that period. You use that value to figure the discounted cash flow.
Using a Terminal Value Calculator
There's more than one way to calculate terminal value. The perpetual growth formula assumes that the company will generate cash flow forever, and incorporates this into the calculations. It's the most complicated formula, heavy on math. Academics and economists like it because with math and economic theory behind it, it isn't as subjective as the exit multiple method.
The liquidation-value method assumes the company will close its doors and sell off its assets at some point in the future. The sale price sets the terminal value. The "exit multiple" approach to terminal value is the one business owners like to use when buying and selling. It doesn't require as much number crunching as the perpetual growth method, and it makes it easy to compare different businesses.
Using Exit Multiples
To use the exit-multiple approach, start with a metric such as EBITDA, which is earnings before interest, taxes, depreciation and amortization. Calculate EBITDA for, say, five years out, then apply a multiplier. The result is the terminal value. Different industries, such as manufacturing or grocery stores, have their own standard multiplier.
For a terminal value example, assume you're looking to set a sale price on your business. You calculate the EBITDA in five years to be $1.2 million. The multiplier in the industry is four. That gives you a terminal value of $4.8 million.
The exit-multiple approach is good if you want to compare the relative value of your company to others in the industry. It's not as effective as the permanent growth formula for calculating the actual value of the business.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com