The Terminal Value (VT) is a critical element of business valuation using the discounted flow method (DCF). It represents the value of the business beyond the explicit forecast horizon (usually 5 to 10 years), assuming that the business continues indefinitely.

Here are the steps and methods of calculation:

1. The Perpetual Annuity Method (Gordon-Shapiro)

This is the most commonly described method. It consists of capitalizing the last normative cash flow infinitely.

The basic formula: The terminal value at year N (end of the explicit period) is calculated as follows:

${\mathbf{TV}}_{\mathbf{N}}\mathbf{=}\mathbf{ }{\mathbf{FCF}}_{\mathbf{N}\mathbf{+}\mathbf{1}}\mathbf{/}\mathbf{(}\mathbf{WACC}\mathbf{–}\mathbf{g}\mathbf{)}$

Or, starting from the flow of year N:${\mathrm{TV}}_{\mathrm{N}}={\mathrm{FCF}}_{\mathrm{N}}\times (1+\mathrm{g})/(\mathrm{WACC}–\mathrm{g})$

• FCF (Free Cash Flow): This is the normative free cash flow. Practitioners insist on the need to adjust this flow so that it is representative of a “cruising speed” (adjustment of working capital and investments to normative levels).
• g (Growth rate): This is the perpetual growth rate of flows.
• WACC: The Weighted Average Cost of Capital (discount rate).

Discounting: This TV amount is a value located in the future (in year N). To obtain its value today, it must be discounted:

$\mathbf{Discounted}\mathbf{ }\mathbf{Terminal}\mathbf{ }\mathbf{Value}\mathbf{ }\mathbf{=}\mathbf{ }{\mathbf{TV}}_{\mathbf{N}}\mathbf{/}{\mathbf{(}\mathbf{1}\mathbf{+}\mathbf{WACC}\mathbf{)}}^{\mathbf{N}}$

2. The Economic Profit Method

A more prudent alternative method is proposed to avoid overvaluing the company. Instead of projecting cash flows infinitely, we project economic performance.

• The principle: It is considered that the company’s ability to “beat the market” (generate a return higher than the cost of capital) will erode over time under the pressure of competition.
• Calculation: The terminal value is calculated by adding to the Invested Capital (in year N) the discounted sum of the future Economic Profit.
• The “Fade”: This approach makes it possible to model a decrease in performance (the fade). For example, it can be expected that the Economic Profit (difference between ROCE and WACC) will gradually decrease (e.g. -1% per year) until it stabilizes or becomes zero, reflecting a more realistic view of long-term competition.

3. Points of vigilance

The calculation of the terminal value is extremely sensitive and carries major risks of evaluation error:

• The weight in the total value: The discounted terminal value often represents a very significant part, or even a majority, of the total value of the company. This means that value is mainly based on very distant and uncertain events.
• The choice of growth rate (g): You must not “make the trees rise to the sky”. It is recommended to be careful:
  • The g-rate must not exceed the growth rate of the economy (GDP) or inflation in the long run.
  • It is even suggested to consider negative growth rates (e.g. -2% or -3%) to reflect the erosion of margins or the end of volume growth.

Consistency of investments: To sustain an infinite growth rate g, the company must continue to invest. The normative flow must therefore include a sufficient level of investment (Capex and WCR) consistent with this growth rate.