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Step 4: Estimate the Terminal Value

After estimating the cash flows for the projection period, the practitioner must derive a terminal value.
The terminal value represents the value of the cash flows to be generated for the years subsequent to the
projection period. fn 23 In other words, the terminal value represents the value of the business at the end
of the projection period. Because the terminal value is the value at the end of the projection period, the
terminal value must also be discounted to the present. In many valuations of distressed companies, the
terminal value can represent a substantial portion, if not the majority, of overall value.

 Normalizing Cash Flow for Terminal Value Estimation. For companies that are expected to
emerge from bankruptcy and become a viable going concern entity, the practitioner should care-
fully evaluate management’s assumptions around future earnings and profitability for reasona-
bleness. Generally, the terminal valuation is based on the assumption that the company’s growth
becomes more predictable and, therefore, can be valued in a manner similar to a dividend in per-
petuity. Any nonrecurring, unusual, or extraordinary revenues or costs should be removed from
this calculation in order to achieve a representative terminal value.

 Methods to Estimate Terminal Value. Three common methods used to estimate the terminal val-
ue are the Gordon growth model, the H-model, and exit multiples.

— Gordon Growth Model. The Gordon growth model is used to estimate the terminal value
under the assumption that the company has entered a steady earnings growth state at the
end of the projection period. The formula mirrors the capitalization of future benefits
method used to estimate the value of a firm currently in stable growth. The earnings
growth rate should reflect stable growth sustainable into perpetuity. fn 24 If growth in the
cash flow has not stabilized at the end of the projection period, it is advisable to lengthen
the projection period or, alternatively, to develop a multistage model. As mentioned pre-
viously, the capitalization of future benefits method is a single-period capitalization mod-
el and tends to be highly sensitive to the assumptions for growth and cost of capital.
Thus, it is important that these assumptions be reasonable and well supported.

— H-Model. A basic two-stage model (as is consistent with an explicit projection period fol-
lowed by a terminal value estimated using the Gordon growth model) assumes a period of
extraordinary growth followed by a constant, long-term growth rate thereafter. The dif-
ference between the final period growth rate in the explicit projection period and the
long-term growth period can be substantial. Therefore, a variant of the two-stage model
referred to as the H-model can be used. In the H-model, a transition period is estimated in
which growth begins at a high rate and declines linearly over the transition period until it

fn 23 Terminal value calculations are made because value estimates typically assume perpetual life for the business enterprise being
valued.

fn 24 If the discount rate has been developed using nominal interest rates (in other words, interests rates that include the rate of infla-
tion), then the perpetual earnings growth rate employed in the terminal value calculation will typically be at least as high as the antici-
pated long-term rate of inflation. However, care must be given to not apply a perpetual earnings growth rate that is excessively high.
For example, a perpetual earnings growth rate of 10% would rather quickly yield earnings estimates that outstrip a company’s capital
base or may represent that the company has captured an unreasonably high market share.

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