The terminal value is a bothersome issue in valuation practices. Unfortunately, the terminal value (or remainder value) is a source of erroneous valuation outcomes. As we have learned in our BriWiFra case from our WACC article, the net present value of cash flows during the forecasting period was 870. The terminal value was 2150. Apparently, the terminal value is 71% of the total firm value.
In the case of early stage high prospective technology ventures, the proportion terminal value to total enterprise value is even larger. Sometimes, the terminal value is larger than the total enterprise value, due to initial cash out during the early stages of the enterprise life cycle.
So, it is understandable that a bit of erroneous assumptions will lead to fully incorrect and unjustifiable valuation outcomes. A bit of understanding of the most common practices might help here.
Terminal value considerations
Zero growth perpetuity is a widely used approach to construct the terminal value. Like we did in our WACC article ending up with an terminal value of 2150. But this assumes an indefinite life time, which is not probable and realistic at all. So this approach will give highly questionable valuation outcomes.
Above that, some business valuators assume an indefinite growth. This might be a tiny bit realistic to a certain extend. As far as this growth is smaller than the rate of economic growth. If not, the company is expected to grow beyond the industry as a whole. A very unrealistic scenario!
So some valuation practitioners try to resolve this by introducing multi stage models. In which growth and associated WACC levels are differentiated over two or more stages. And an even better approach is to introduce an enterprise life cycle.
In our BriWiFra case, William introduced the limited remainder period or so called annuity approach. The future cash flow will only continue during a fixed period of time, i.e. 5 years. This would sound much realistic to many ears, except for Brians’ of course.
This annuity concept would also be possible in combination with a specific early years growth and later years decline rate. Ending up with an even more realistic valuation outcome!
So, the calculation of the terminal value is certainly not an easy task. Many life cycle approaches can be assumed and motivated to come up with a valuation result. Which is, of course subject to even more disputes between stakeholders!
Clearly, from the arithmetic, enterprise value is strongly thriven by growth. Assuming just a very little more growth has an increasingly effect on the firm value. But are such growth assumptions in respect to terminal value realistic?
At first there is the question whether of not the company will be successful in realising such growth, due to market circumstances and the firms’ competitive edge. But next, there is also the question of required investment levels to achieve such a growth, constituting a cash drain from the operation to achieve such a growth.
Therefore, the basic formulas using NOPATs, WACCs and growth rates G appear to be quite simple. But the challenge is the sensible application of these.