What is the terminal value? Avoid 6 mistakes

After analysing the main errors in flow forecasting and in the assessment of the cost of capitalNow it is time to identify the main problems or failures in calculating the terminal value.

What is terminal value?

The discounted cash flow valuation method is based on the ability of the company in question to generate wealth in the future. To this end, the company's cash flows are projected and discounted at a rate accordingly.

One of the assumptions taken into account when estimating cash flows is that the activity of the company will continue for an indefinite period of time. In other words, the so-called basic principle of going concern.

This would require projecting these flows to infinity and then calculating them at present value. Clearly, this approach is impractical, so it is common to divide the life of the company into two periods:

• Discreet: for a number 'n' of exercises ranging from 3 to 10 (5 being the most common).
• Infinity: from period 'n+1', which is simplified by the calculation of the terminal value.

Therefore, the terminal value captures the future value of the firm's expected cash flows over the remainder of its infinite life, after the discrete period. It is calculated on the assumption that from year 'n+1' onwards the company's cash flows will continue to grow at a constant rate. Thus, the terminal value can be thought of as an annuity.

For all these reasons, it is essential to calculate it correctly, because, however trivial it may seem, it is as important as any other cash flow.

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Common errors in terminal value calculation

There are 6 main errors when estimating terminal value. Below, we list them in order to be aware of them and avoid them in future valuations that may be carried out in the field of corporate finance:

1. Inconsistencies in the flow used to calculate a perpetuity

Particular attention should be paid to the cash flow pertaining to year 'n', as this is the year in which the cash flow for year 'n' is the most important. cash flow on which the projections will be carried out to infinity. Thus, if the aforementioned year is not representative due to special circumstances in that year, or if any of its items are unsustainable in the long term, the necessary adjustments have to be made.

For example, consider an exercise where fixed asset investments are less than the expected depreciation. This situation taken to infinity would lead to negative net fixed assets, which makes no sense at all.

Therefore, it is important to analyse the cash flow in year 'n', and make any necessary adjustments so that it can be considered a reasonable, consistent and sustainable cash flow over the long term.

2. Use arithmetic rather than geometric averages to estimate growth.

Of course, the geometric mean is a much more accurate and precise indicator than the arithmetic mean, especially for long periods of time and with large variations in the values being calculated. Therefore, it is more convenient to use the geometric mean in the calculation of the various items, to be included in the terminal value formula.

3. Calculating the residual value with a wrong formula

When calculating the residual value as an increasing perpetuity, the correct formula is as follows:

VT_t = CF_n+1 /(K - g)

The most common mistakes arise from the use of a cash flow pertaining to year 'n', or to use the cash flow pertaining to year 'n+1' multiplied by the expected growth. The correct formula includes the future value of the annuity, i.e. the value of the annuity in year 'n+1'.

4. Assume that perpetuity begins one year earlier.

It is very common to make mistakes in the timeline of cash flows, anticipating or delaying some of them incorrectly. To avoid this mistake, it is very useful to draw a timeline with the different cash flows. cash flows.

5. Confusing growth rate with reinvestment rate

The growth rate is to be taken for the estimation of the terminal value, and not the reinvestment rate, as it does not represent the growth of the company.

6. Use an unsustainable flow growth rate in perpetuity.

The assumption of constant growth towards infinity of the company requires the use of a commensurate but not disproportionate rate, always bearing in mind that this is the rate we are assuming for an infinite number of years.

This will require taking into account the competitors, the market situation, the company's future prospects and, above all, the common sense.

Download here the complete guide to company valuations:

In this valuation guide you will find a detailed description of the essential aspects of company valuation.
What is the difference between value and price?
What valuation methods exist?
What are the key steps for the DCF (discounted cash flow) method?

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