Terminal Value

No one can forecast a company's cash flows year by year forever, so discounted cash flow models forecast in detail for 5 to 10 years and then estimate a single terminal value to capture everything after. Terminal value often accounts for 60% to 80% of a DCF's total value, which means its assumptions matter enormously. There are two standard methods: the perpetuity growth (Gordon growth) method and the exit multiple method. Good practice is to use both and check that they tell a consistent story.

Method 1: perpetuity growth (Gordon growth)#

Assumes free cash flow grows at a constant rate forever after the forecast period.

terminal value at year n = FCF_(n+1) / (WACC - g) = FCF_n × (1 + g) / (WACC - g)

• g: long term growth rate, typically 1.5% to 3%, at or below expected long run nominal economic growth.
• WACC: discount rate. See WACC and Cost of Equity.

The growth rate must be lower than the discount rate; as g approaches WACC, terminal value explodes.

Method 2: exit multiple#

Assumes the business is sold at the end of the forecast period at a multiple of a financial metric, often EV/EBITDA.

terminal value at year n = EBITDA_n × exit multiple

Comparing the methods#

Cross checking#

• Implied multiple: convert a perpetuity growth terminal value into an implied EV/EBITDA. If it is 25x for a mature business, something is off.
• Implied growth: convert an exit multiple terminal value into an implied perpetual growth rate. If it implies 6% growth forever, the multiple is too high.
• Reinvestment consistency: growth requires investment. A rule linking them is g = reinvestment rate × return on new invested capital. Assuming high growth with little reinvestment is inconsistent. See ROE, ROA and ROIC.

Choosing a sensible terminal growth rate#

• Do not exceed long run nominal GDP growth for the economies the company operates in, often around 3% to 4% for developed economies in nominal terms, and many analysts use 2% to 3%.
• Mature or declining industries may warrant lower or even negative growth.
• Make sure the business has reached a steady state by the end of the forecast period, with stable margins and reinvestment.

Common mistakes#

• Terminal growth too close to WACC.
• Using a peak cycle multiple for the exit.
• Ending the forecast before the company is mature.
• Not discounting the terminal value back to today.

Frequently asked questions#

What is terminal value?#

The estimated value of a company's cash flows beyond the explicit forecast period in a DCF model.

What is the Gordon growth model?#

A formula that values a stream of cash flows growing at a constant rate forever: next year's cash flow divided by the discount rate minus the growth rate.

What terminal growth rate should I use?#

Usually a rate at or below long term nominal economic growth, often 2% to 3%, and lower for mature or declining businesses.

Next, learn how to set the discount rate in WACC and Cost of Equity.