Also known as horizon or continuing value, the terminal value has to do with the anticipated value of an asset at the end of a specified time period. The figure normally takes into account such factors as the rate of interest that applies to the asset from the current date to the end of the period under consideration, as well as the current value of the asset itself. This type of projection is helpful when planning budgets for future operations and arranging the cash flow to meet those budgets. The approach can also be used to evaluate the viability of acquiring an asset, since it involves determining how much of a gain the investor can reasonably expect to achieve by a given point in time.
There are two common approaches to calculating terminal value. One approach is known as the perpetuity formula, or the perpetuity growth model. The idea with this approach is to identify the free cash flows that are generated on an ongoing basis, thus impacting the terminal value of the asset at the end of each cycle or period under consideration. With this method, the investor can determine if the increase in value, as well as the generation of interest income from the asset, is likely to continue from one period to the next in a more or less consistent manner. This can be especially helpful if the goal is to use that interest income as part of the funding for successive budgets.
The other common methodology used to determine terminal value is known as the exit approach. Here, there is an assumption that the asset will be sold at the end of the projected period. This allows the investor to determine if the rate of return that is generated by the end of the period under consideration is sufficient to merit the degree of risk involved with the acquisition of the asset. Applying this approach can make it much easier to determine if the investment is a good fit for the goals of the investor, or if he or she should move on and seek a different investment opportunity.
Both approaches to terminal value have potential liabilities as well as benefits. With the perpetuity formula, there is an increased use of estimates in determining the value of the asset at the end of the specified period. This increases the margin for error somewhat. Should the assumptions made regarding the growth rate and other factors prove to be inaccurate, the value will be less than projected, and could undermine the reason for acquiring the asset in the first place.
The exit approach, while simpler than the perpetuity approach, also relies heavily on the accuracy of the assumptions made about growth up to the end of the specified period. Unanticipated events may impact the growth rate, and thus result in a lower value than originally projected. Still, this approach is often favored by financial experts, especially investment bankers. Keeping in mind that the projection of terminal value is based on assumptions regarding the multiple factors involved, making those factors as realistic as possible will help to improve the chances of accurately arriving at a figure that is reliable, and thus is more useful to the investor.