Terminal Value Methods

A discounted cash flow model can only forecast in detail for so long — five years, maybe ten, before the guesses get silly. But the company keeps operating after that. Terminal value is the single number that stands in for every cash flow from the end of the forecast to forever, and it is typically 60–80% of a DCF's total value. Get the terminal value wrong and the five years of careful modeling in front of it barely matter.

There are two standard ways to build it.

Perpetuity growth treats the last forecast year's cash flow as growing forever at a constant rate:

$$TV_n = \frac{CF_{n+1}}{r - g} = \frac{CF_n (1+g)}{r - g}$$

In words: take next year's cash flow, divide by the discount rate minus the assumed forever-growth rate. This is a growing perpetuity, and the whole formula rests on one very strong assumption — that $g$, held constant to infinity, is realistic. $g$ is almost always capped near long-run GDP growth (2–3%), because no company can outgrow the economy forever without eventually becoming the entire economy.

Exit multiple instead assumes the company gets sold, at the end of the forecast, for a multiple of its earnings — the same multiple a buyer would pay for a similar mature business today:

$$TV_n = \text{Multiple} \times \text{Metric}_n$$

typically EV/EBITDA. This sidesteps guessing a growth rate but imports whatever the market currently pays for that industry, which is itself a bet on today's sentiment holding into the future.

A worked example

Year-5 free cash flow is $100m, the discount rate ($r$, WACC) is 9%, and long-run growth ($g$) is 2.5%.

$$TV_5 = \frac{100 \times 1.025}{0.09 - 0.025} = \frac{102.5}{0.065} \approx \$1{,}577\text{m}$$

That $1,577m sits in year 5, so it still needs discounting back to today at 9% over five years: $1{,}577 / 1.09^5 \approx 1{,}025$, i.e. $1,025m.

Cross-check with an exit multiple: if year-5 EBITDA is $220m and comparable mature companies trade at 8x EV/EBITDA, $TV_5 = 220 \times 8 = 1{,}760$, i.e. $1,760m — in the same neighborhood as the perpetuity-growth answer, which is the point of running both.