A private equity investor is considering an investment in a venture capital firm, and is looking to calculate the firm’s terminal value. The investor determines that there is equal likelihood of the following:
Expected firm earnings are $2.5 million with a P/E ratio of 8.
Expected firm earnings are $3.0 million with a P/E ratio of 10.
The firm’s expected terminal value, and the analysis used by the investor, respectively, is:
The investor is using scenario analysis to determine the venture capital firm’s terminal value. The terminal value under each scenario is calculated by multiplying the expected earnings by the P/E ratio:
Scenario 1: $2.5 million × 8 = $20 million Scenario 2: $3.0 million × 10 = $30 million
The expected terminal value is then the weighted value under each scenario:
Expected terminal value = (0.50)($20 million + $30 million) = $25 million.
