Why Terminal Value Exists
You can't forecast forever. Terminal value captures all cash flows after the explicit period, assuming the business has reached steady state.
- ✓Explain the purpose of terminal value
- ✓Define 'steady state' and why the final forecast year must represent it
- ✓State the two methods used to compute it
Forecasting year-by-year past ~5 years is false precision - nobody knows 2035's revenue line by line. So we forecast explicitly until the business reaches a steady state, then collapse everything beyond into a single terminal value (TV).
The point where the company grows at a stable, sustainable rate and margins have normalized - not the peak or trough of a cycle. The final explicit year must represent , because extrapolates from it forever.
(1) Perpetuity Growth Method - assume grows at a constant rate forever. (2) Exit Multiple Method - assume the business is 'sold' at a multiple of its final-year . Pros compute both and use each to sanity-check the other.
Both methods give the as of the end of the projection period (say, end of year 5). It still has to be discounted back to today like any other future cash flow. Forgetting this second discount is a classic, costly error.
Why must the final year of the explicit forecast represent 'steady state'?