Terminal value

A DCF forecasts cash flows year by year for a limited period, often five or ten years. The business does not stop at the end of the forecast, so the terminal value captures everything after it in a single number.

Two ways to estimate it

The perpetuity growth method, also called the Gordon growth method, assumes free cash flow grows at a constant rate (g) forever. Take the free cash flow in the final forecast year, grow it by one year, and divide by the discount rate minus the growth rate. The exit multiple method instead applies a multiple, usually EV/EBITDA, to the final year's EBITDA, on the assumption that the business could be sold at a multiple like those of similar companies today. The two methods should give answers in the same range. If they do not, one of the assumptions is off.

Discounting it back

The terminal value is a value at the end of the forecast, not today. Discount it by the same factor as the final year's cash flow: PV of TV = TV ÷ (1 + WACC)^n, where n is the last forecast year. Forgetting this step is one of the most common errors in DCF models.

Choosing the growth rate

The growth rate must be below the discount rate, or the formula breaks. It should also be no higher than the long-run nominal growth of the economy, because no company can outgrow the economy forever. Growth also needs investment: a company growing faster must reinvest more of its profit, so the free cash flow in the formula should allow for that.

Why it dominates the answer

In a typical five-year DCF, the forecast years may explain only a quarter or a third of the value, and the rest comes from the terminal value. That is why small changes in two assumptions, the discount rate and the growth rate, move the whole valuation. The analysis of why terminal value dominates valuations works through an example, and the DCF sensitivity calculator lets you test your own.

Common mistakes

• Setting the growth rate close to the discount rate, which makes the terminal value explode.
• Using a high near-term growth rate as the perpetual rate.
• Not reporting the terminal value's share of the total. Always show it, with a sensitivity grid.
• Mixing nominal cash flows with a real discount rate, or the reverse.

Questions investors ask

What is a reasonable terminal growth rate? One at or below long-run expectations for nominal growth in the economy, and always below the discount rate. Test a range rather than relying on a single figure.

Should I use the perpetuity growth or the exit multiple method? Use one and check it against the other. The multiple that a growth-based terminal value implies should look sensible next to today's multiples for similar companies.