Estimating Terminal Value

Introduction

The terminal value is the value of the project’s expected cash flow beyond the explicit forecast horizon. An estimate of terminal value is critical in financial modelling because it accounts for a large percentage of the project value in a discounted cash flow valuation. This tutorial focuses on ways in which terminal value can be calculated in a project finance model.

In our previous tutorial titled Formula to Calculate NPV in Excel we discussed how NPV can be used to calculate the value of a project / investment based on future cash flows. A firm or project potentially has infinite life and its value is hence the NPV of future cash flows forever.

However, forecasting results beyond certain periods is impractical and exposes such projections to a variety of risks. This limits their validity, with great uncertainty involved in predicting the project revenue / cost components, industry or macroeconomic conditions beyond a few years.

To capture the value at the end of forecasting period, a terminal value is included. Terminal value allows for the inclusion of the value of future cash flows occurring beyond a several year projection period while satisfactorily mitigating many of the problems of valuing such project cash flows.

A high-quality estimate of terminal value is critical because it often accounts for a large percentage of the total value of the project in a discounted cash flow valuation. As a result, financial analysts and modellers should be familiar with the mechanics of terminal value and how it is calculated in order to ensure an accurate financial modelling and valuation exercise.

This tutorial with the accompanied excel workbook illustrates various ways in which terminal value can be calculated.

Method to calculate Terminal Value

Three methods will be discussed in this tutorial

• Multiple EBITDA approach
• Perpetuity approach
• Perpetuity with Growth approach

In practice, academics tend to use the Perpetuity Growth model, while project financiers favour the Exit Multiple approach.

Ultimately, these methods are two different ways of saying the same thing. For both terminal value approaches it is essential to use a range of appropriate discount rates, the multiples and perpetuity growth rates in order to establish a functional valuation range.

Multiple EBITDA approach

The Multiple EBITDA approach measures the firm value that is the value of the business operations. In calculating enterprise value, only the operational value of the business is included. The formula to calculate the terminal value is shown below.

EBITDA t = EBITDA at the last year of projected period
EBITDA multiple = EBITDA multiplier (x)

The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied firm value.

A publicly-traded comparable company multiples is used in the calculation. This method is the easiest approach but depending on the purposes of the valuation, the estimated EBITDA multiple may not provide an appropriate reference range.

There are some variations of multiple used in the terminal multiple approaches:

• P/E multiple
• Market to Book multiple
• Price to Revenue multiple
• EBIT multiple
• Multiple EBITDA approach

Perpetuity Growth approach

The Perpetuity Growth approach assumes that free cash flow will continue to grow at a constant rate into perpetuity. The Terminal Value can be estimated using this formula. 

FCF = Free cash flow @ the last year of projected period
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate (%)

What growth rate do we use when modelling? The constant growth rate is called a stable growth rate. While past growth is not always a reliable indicator of future growth, there is a correlation between current growth and future growth. A project growing at 10% currently, probably has higher growth and a longer expected growth period than one growing at 5% a year now.

Estimation of the growth rate used in this approach makes it challenging because inaccuracy in the assumption can provide an improper value. Hence, some analysts sometimes drop the growth rate in the formula to arrive at a more conservative terminal value.

Modelling Terminal Value

For illustration on how the Terminal Value is estimated and used for valuation purpose in a project finance model, we have prepared an Excel workbook. The example assumes that a project has 12-month constructions and quarterly cash flow projections of 10 years. Three methods are demonstrated to estimate the Terminal Value. The assumptions are depicted in the screenshot below.

Screenshot 1: Inputs page

In all methods, we need to establish the EBITDA or Free cash flow at the last year of the projected period. The easiest way to do this is perhaps by constructing a simple binary
(1, 0) flag.

Screenshot 2: Constructing binary flag for Operations end

The terminal value calculation is very straightforward. Various methods of calculating the terminal value are shown in the screenshots below.

Screenshot 3: Multiple EBITDA approach

Screenshot 4: Perpetuity Growth approach

The final step is to add the terminal value into the project cash flow before calculating the NPV. In this example it is assumed that the Perpetuity approach is selected.

Screenshot 5: Project Valuation

Terminal Value modelling considerations

Few considerations in calculating terminal value in project finance modelling:

• Carefully establish the cash flow or EBITDA at the last year of the projected period.
  The usual mistake is to capture the cash flow falls in the last quarter / month instead of summing up those in the last year of projected period (refer to Screenshot 2 and 3).
• Reminded to add the terminal value into the project cash flow before calculating the NPV.
  The project valuation does not stop at a terminal value calculation, Remember to add the calculated terminal value into the project cashflow for NPV calculations such as illustrated in Screenshot 5.
• Select the appropriate multiple, growth rate and discount rate for the risk profile of the project as it is a key variable in the terminal value calculation
• Clearly show if the calculation is pre or post tax
• Refer to previous tutorial Formula to Calculate NPV in Excel for tips and considerations when performing the NPV calculation

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