We have previously discussed the income approach and how its results are driven in particular by the underlying projections of income, the terminal value and the assumed discount rate.

In our last blog post, we looked at the role of projections in the income approach and, specifically, how small changes in projected income can have large impacts on valuation outcomes. Today, we turn to the second major parameter of the income approach: the terminal value.

WHAT IS A TERMINAL VALUE?

As discussed previously, the income approach is based on projections of future income, typically over a period of 5 to 15 years, but businesses are generally expected to continue generating income well beyond that period.

How, then, do we account for income generated beyond the explicit projection period? The answer lies in the terminal value. The terminal value captures the value of all income generated beyond the explicit forecast horizon without this income needing to be modelled.

HOW DOES IT WORK?

Assuming a "going concern" scenario (i.e., assuming the company continues operating), two main approaches are commonly used in practice to calculate the terminal value:

(1) Growth Method

The growth method (also referred to as the perpetuity growth method or Gordon Growth Model) assumes that the company continues to grow at a constant rate, g, indefinitely. Starting from the final modelled income value (CFₙ), income is assumed to follow a path with a constant growth rate.

The terminal value under this approach is calculated as:

TV = CFₙ × (1 + g) / (r – g)

where r represents the discount rate and n the last year of the explicit forecasting horizon.

The growth method is generally most appropriate when the assumption of stable long-term growth is reasonable. This is often the case for large, established companies operating in mature and stable markets.

(2) Exit Multiple Method

The exit multiple method implicitly assumes that, following the explicit projection horizon, the company will be sold at a value based on a multiple of a financial metric, most commonly EBITDA.

Under this approach, the terminal value is estimated by applying an appropriate multiple to the company's projected financial performance at the end of the forecast period.

The terminal value is calculated as:

TV = EBITDA_n+1 x Exit Multiple

The exit multiple approach is particularly useful for companies where a constant-growth assumption is not justified, such as start-ups or businesses operating in rapidly changing markets. However, it can also serve as a useful cross-check against the growth method.

As expected, both approaches depend heavily on the underlying assumptions and parameters. To illustrate the relative sensitivity of these assumptions, we have designed the tool below, which allows you to calculate terminal values under different assumptions.

The tool first allows you to select the methodology (Growth Method or Exit Multiple Method) and then specify the relevant parameters. For the growth method, you can adjust the growth and discount rates; for the exit multiple approach, you can specify the multiple directly. We have fixed the underlying cash flows using the baseline scenario from the Dell case.

As the tool illustrates, even relatively small changes in assumptions can have significant impacts on value:

• Using a growth rate of 2%, decreasing the discount rate from 10% to 9% increases the valuation from USD 50.4m to USD 57.3m.
• Increasing the exit multiple from 19 to 20 increases the valuation from USD 53.2m to USD 55.3m.

So what?

The next question, of course, is whether the terminal value actually matters. Does it make up a large enough portion of a company's value to justify closer scrutiny? The data suggests that it does. According to Holland (2018), terminal value can account for around 80 percent of a company's total valuation. We would therefore argue that the terminal value is not only worth examining closely, but is also an area that frequently becomes contested.

Given the importance of the terminal value, how can we improve confidence in the results? A number of practical steps can help:

• Cross-checking methodologies: Comparing results across different terminal value approaches can help identify unreasonable outcomes.
• Carefully assessing underlying assumptions: As discussed above, discount rates and the choice of multiples will be covered in upcoming blog posts. For growth assumptions specifically, a common rule of thumb is that sustainable long-term growth should typically fall somewhere between inflation and expected GDP growth. Assuming a growth rate above GDP growth would imply that the company eventually grows faster than the overall economy indefinitely — an assumption that can quickly lead to unrealistic conclusions. Estimates published by the IMF can provide useful benchmark values.

OUTLOOK

For many practitioners, terminal value remains one of the main criticisms of the income approach because such a large portion of value often depends on it. However, the main takeaway should not be that terminal values are inherently unstable or unreliable. Rather, it should be that most income approach valuations require a carefully considered terminal value based on assumptions that are robust, transparent, and economically reasonable.

RESOURCES

• IMF estimates of real GDP growth: https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD
• IMF estimates of inflation: https://www.imf.org/external/datamapper/PCPIPCH@WEO/CIS

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