Terminal value: how to calculate it, with a small business example

Short answer: terminal value is the value of all the cash a business makes after the last year of a forecast, in one number. There are two ways to work it out. The perpetuity growth method (also called the Gordon growth model) is last year’s free cash flow × (1 + long-term growth) ÷ (discount rate − long-term growth). The exit multiple method is last year’s EBITDA × the multiple a buyer would pay. Either way, the result is a value at the end of the forecast, so you discount it back to today before adding it to the forecast years. For a cleaning company with $121,000 of free cash flow in year 5, a 25% discount rate and 2% growth, the terminal value is $536,609, worth $175,836 today, which is 37% of the business’s value.

The terminal value formulas

Method	Formula	What you have to assume
Perpetuity growth	Final year free cash flow × (1 + g) ÷ (r − g)	g, how fast the cash grows for ever, and r, the discount rate
Exit multiple	Final year EBITDA (or profit) × multiple	The multiple a buyer would pay at the end of the forecast
Present value of either	Terminal value ÷ (1 + r) to the power of the number of forecast years	The same discount rate as the forecast years

g must be below r, or the formula gives a nonsense answer (at g = r it divides by zero). In practice g is at or below inflation, because no business outgrows the economy for ever. The ”× (1 + g)” is there because the formula needs the cash for the first year after the forecast, not the last year in it.

A worked example: a commercial cleaning company in Brisbane

These figures are made up, and they continue the example in the discounted cash flow guide. Sam’s cleaning company forecasts free cash flow of 104,000, 108,000, 112,000, 117,000 and 121,000 over the next five years. At a 25% discount rate those five years are worth $297,236 today. The terminal value covers year 6 onwards.

Method 1: perpetuity growth

Step	Working	$
Year 6 free cash flow	121,000 × 1.02	123,420
Divide by r − g	0.25 − 0.02 = 0.23
Terminal value at the end of year 5	123,420 ÷ 0.23	536,609
Discount factor for 5 years	1 ÷ 1.25^5	0.32768
Present value of the terminal value	536,609 × 0.32768	175,836

Business value: 297,236 + 175,836 = $473,072.

Method 2: exit multiple

Sam’s forecast has $150,000 of EBITDA in year 5. Suppose a business broker says similar cleaning companies sell for about 3.5 times EBITDA (an assumption for this example; ask a broker what applies to yours).

Step	Working	$
Terminal value at the end of year 5	150,000 × 3.5	525,000
Present value of the terminal value	525,000 × 0.32768	172,032

Business value: 297,236 + 172,032 = $469,268.

Check one method against the other

The two answers are within $4,000 of each other, which is a good sign. Each method implies a figure for the other:

• The perpetuity value of $536,609 is 3.58 times year 5 EBITDA (536,609 ÷ 150,000). If brokers say businesses like Sam’s sell for 2 times, the growth or discount rate is too generous.
• The exit multiple of 3.5 implies long-term growth of about 1.6%: solving 525,000 = 121,000 × (1 + g) ÷ (0.25 − g) gives g = 10,250 ÷ 646,000. If a multiple implies 8% growth for ever, the multiple is too high for a 25% discount rate.

Work out both, and if they disagree by a lot, find out which assumption is doing it before you trust either.

Why the terminal value matters so much

The present value of the terminal value at different discount rates and growth rates, with its share of the business value:

Long-term growth	Discount rate 20%	Discount rate 25%	Discount rate 30%
0%	243,136 (42%)	158,597 (35%)	108,629 (29%)
2%	275,554 (45%)	175,836 (37%)	118,716 (31%)
4%	316,077 (49%)	196,358 (40%)	130,355 (33%)

Three things follow:

• A third or more of the value sits after year 5. For a large company valued at a low discount rate it is often well over half. That is why the terminal value deserves more care than any single forecast year.
• The discount rate matters more than the growth rate. Moving growth from 0% to 4% changes the terminal value by about $38,000 at 25%; moving the rate from 25% to 20% changes it by about $100,000.
• The final forecast year is multiplied many times. At 25% and 2%, every dollar of year 5 cash is worth about $4.43 of terminal value (536,609 ÷ 121,000). If year 5 includes a one-off $20,000 van purchase, free cash flow drops to 101,000 and the present value of the terminal value falls by about $29,000, for a cost that does not repeat. Year 5 should be a normal year.

How to get the figures from Xero

1. Run Accounting › Reports › Profit and Loss for the last full year. The EBITDA calculator turns it into EBITDA, the figure an exit multiple applies to.
2. Run the Statement of Cash Flows for the same year and work out free cash flow: operating cash flow less spending on equipment. The free cash flow calculator does this, and the unlevered free cash flow guide shows how to put the interest back so the figure is before the loans.
3. Forecast five years from there, as in the discounted cash flow guide, and make sure year 5 has normal equipment spending.
4. Apply both terminal value methods to year 5, discount each by 1 ÷ (1 + r)^5, and compare.

In a spreadsheet, with year 5 free cash flow in B6, the rate in B8 and growth in B9: =B6*(1+B9)/(B8-B9) gives the terminal value, and =B6*(1+B9)/(B8-B9)/(1+B8)^5 its present value. Menu names move between Xero releases and regions, so search Xero Central for the report name if your screen differs.

Common mistakes

• Adding the terminal value without discounting it. $536,609 added straight to the five years gives $833,845, which overstates Sam’s business by more than $360,000. The terminal value is a figure at the end of year 5.
• Discounting it by six years. The perpetuity formula already gives a value at the end of year 5, even though it starts from year 6 cash. Discount by five years.
• Leaving out the × (1 + g). It is a small error at 2% growth but it understates the value every time.
• Growth close to the discount rate. At 25% and 20% growth the formula says year 5 cash is worth 24 times over. Long-term growth should be at or below inflation.
• Using a multiple from the wrong kind of business. Multiples for listed companies are far higher than for small owner-run ones. Use what businesses of your size and type actually sell for, and apply it to the same figure (EBITDA, profit or seller’s discretionary earnings) the multiple was quoted on.
• Mixing levered and unlevered figures. Free cash flow before interest gives the value of the whole business, and the loans come off afterwards. Do not take interest off the cash and the loans off the value as well.

Common questions

What is terminal value? Terminal value is the value of a business’s cash beyond the last year of a forecast, rolled into one figure at the end of that year. In a discounted cash flow it is added, after discounting, to the present value of the forecast years to give the value of the business.

How do you calculate terminal value? With the perpetuity growth method, multiply the final year’s free cash flow by one plus the long-term growth rate, then divide by the discount rate minus the growth rate. For example, 121,000 × 1.02 ÷ (0.25 − 0.02) = 536,609. With the exit multiple method, multiply the final year’s EBITDA by the multiple a buyer would pay.

What growth rate should I use for terminal value? A rate at or below long-term inflation, often 0% to 3%. A business cannot grow faster than the economy for ever, and the rate must always be below the discount rate.

Should I use perpetuity growth or an exit multiple? Use both and compare. The perpetuity method rests on your own cash and discount rate; the exit multiple rests on what buyers pay for similar businesses. If the two differ a lot, one of the assumptions is out of line.

Why is terminal value such a large part of a DCF? Because it stands for every year after the forecast, while the forecast covers only five. For a small business valued at 20% to 30% it is often a third to a half of the total; at lower discount rates it is usually more.

Can terminal value be negative? Only if the final year’s free cash flow is negative, which means the forecast ends with the business still using up cash. In that case extend the forecast until the cash is positive and steady, or value the business on its assets instead.

See your figures every Monday

ReportPilot reads your Xero figures and sends a short plain-English email every Monday. It covers sales and profit against last month and the same month last year, the cash in the bank against the end of last month, money owed to you that is past due and by whom, and bills due in the next two weeks against your cash. It does not value your business, but it shows the trend in the figures a buyer will look at first. It asks Xero for read-only access, and there is a 14-day free trial with no card.