Terminal value (TV) is a term used in valuing stocks. It represents the discounted present value of all future cash flows, including reinvested dividends or capital gains distributions, that a company will generate over its lifetime. TV can be thought of as the size of an apple, while a stock’s intrinsic value can be seen as the price at which an apple will sell on any given day. Once you know how to come up with TV for any given stock and some of its underlying drivers, it becomes easier to determine whether or not the stock is bearish or bullish concerning its intrinsic value.
Why TV matters to investors
To understand what TV is, let's first consider a simple example. If I invest $1000, and the company makes $100 of profit over the next year, my ultimate goal is to be sure that I get that money back with zero additional risk at the end of one year. That way, I will have gotten my original investment back with no more than a 1% risk exposure. On top of that, all future cash flows will go straight into reinvestment into more shares or buying more stocks in the hope of even greater profit. I want my money back as fast as possible with as little risk in the simplest terms. The problem is that this simple scenario only illustrates one side of investing. In real life, many variables can come into play and affect a company's potential revenue and profit growth. This includes interest rates, inflation rates, exchange rates, and many more.
What is Terminal Value (TV)
Terminal value (TV) represents the sum of all future cash flows that a company is assumed to generate over its lifetime when discounted at an appropriate discount rate. The moment we encapsulate all future cash flows in one single number gives us a simplified picture of what we can expect from such a business over time. It helps investors determine whether or not the price at which a stock is selling is undervalued or overvalued.
What Is Intrinsic value
Intrinsic value (IV) represents the sum of all future cash flows generated by a company's existing assets. It also allows us to estimate the future economic benefit of owning a stock. It measures the difference between what you expect from an investment in a given asset and what you have to pay for it.
If the stock happens to sell for more than its intrinsic value, you can make money by purchasing shares of that company at a discount.
Intrinsic Value (IV) is calculated by subtracting the market price from estimating a firm's worth based on its future cash flows.
The underlying drivers of Intrinsic Value (IV) are typically future cash flows, growth rates, discount rates, or other factors that affect future cash flow estimates.
As long as you properly understand how to find TV and IV, it will be easier to determine whether or not a stock is undervalued or overvalued concerning its intrinsic value.
How to find the terminal value of a company?
To find a stock's TV is much easier to do this when you are familiar with the different indicators and terms used in valuing stocks. For this article, we will use two fundamental indicators that can be used to value stocks: EBITDA and FCF.
EBITDA vs FCF
For EBITDA or FCF to fully value a company's future cash flows, it needs to be accounted for as an expense in its income statement (like depreciation). It needs to be adjusted for interest, taxes, and other non-cash expenses.
To properly determine a stock's TV, we will use DCF analysis.
Calculating Valuation with Discounted Cash Flow Analysis
Discounted cash flow analysis (DCF) determines a company's value by taking future cash flows, discounting them to their present value, and adding them together. We will use DCF analysis to find the intrinsic value of a company's stock before comparing it with the stock's actual price. We will then compare the current price of the given stock with its intrinsic value to see if it is overvalued or undervalued concerning its true worth.
The steps in discounted cash flow analysis (DCF) are:
- Estimate the company's future revenues and expenses
- Select a discount rate that is used to reduce these future cash flows to their present value
- Add all of the discounted cash flows together to find the company's present value
- Determine if the company is undervalued or overvalued based on its present value, compare it with its market price, and make your investment decision.
If the cash flow and valuation analysis (DCF) methods were used to value a company, we would know that all future cash flows that the company can generate will be accounted for in one single number. This number could be represented as TV, representing how much money we can expect to get back from the stock if we invest our money.
To find this TV figure, you need to use some basic principles of DCF analysis, which are outlined below:
- We estimate a company's future cash flows by adding revenues and expenses together over some time (usually one year).
- Interest expenses, taxes, and other non-cash expenses are also added up.
- These numbers are then discounted back to the present day using an appropriate discount rate.
- Future cash flows are then added up to get a single number that can be used to estimate the stock's TV value.
- This TV value can then be compared to the stock's market price to see if it is undervalued or overvalued relative to its actual worth.
