Terminal Value

Valuing Cash Flows Beyond Your Projection Period

What is Terminal Value?

Terminal Value represents the present value of all future cash flows beyond your explicit forecast period.

In a typical 5-year DCF model, you project cash flows for years 1-5. But companies don't stop generating cash after year 5 - they continue operating indefinitely (in theory). Terminal Value captures this ongoing value.

Critical Point: Terminal Value typically represents 60-80% of total enterprise value in most DCF models. Small changes in terminal value assumptions can dramatically impact your valuation.

The Perpetuity Growth Method

Terminal Value = FCFn+1 / (WACC - g)

Where FCFn+1 = Final Year FCF × (1 + g)

Formula Components:

  • FCFn+1 = Free cash flow in the first year after your projection period
  • WACC = Weighted Average Cost of Capital (discount rate)
  • g = Perpetual growth rate (usually 2-3%)
The Math Behind It: This formula comes from the Gordon Growth Model, which values a perpetuity (infinite stream) of growing cash flows. It assumes the company will grow at a constant rate forever.

Terminal Value Calculation Example

Given Information:

  • Year 5 Free Cash Flow = $500M
  • WACC = 10%
  • Terminal growth rate (g) = 2.5%

Step 1: Calculate Year 6 FCF (FCFn+1)

FCF6 = Year 5 FCF × (1 + g)

FCF6 = $500M × 1.025 = $512.5M

Step 2: Calculate Terminal Value

TV = FCF6 / (WACC - g)

TV = $512.5M / (0.10 - 0.025)

TV = $512.5M / 0.075

Terminal Value = $6,833M

Remember: This terminal value must still be discounted to present value using your WACC discount factor for Year 5 to get its contribution to enterprise value.

Choosing the Right Terminal Growth Rate

The terminal growth rate is the most sensitive assumption in your DCF. Here's how to choose it:

General Guidelines:

Typical Ranges
  • 2.0-2.5%: Conservative (GDP growth)
  • 2.5-3.0%: Moderate (nominal GDP + inflation)
  • 3.0-4.0%: Aggressive (use with caution)
  • >4.0%: Rarely justified
Key Considerations
  • Cannot exceed long-term GDP growth
  • Consider industry maturity
  • Account for competitive dynamics
  • Factor in economic growth expectations
Critical Rule: Terminal growth rate must be LESS than your WACC, or the formula breaks (division by zero or negative). If g ≥ WACC, your assumptions are unrealistic.

Alternative Method: Exit Multiple

Instead of perpetuity growth, you can estimate terminal value using an exit multiple:

Terminal Value = Final Year EBITDA × Exit Multiple

Or use EBIT, Revenue, or other metrics

When to Use Exit Multiples:

  • When you have reliable peer trading multiples
  • For mature, stable businesses
  • When perpetuity growth seems unrealistic
  • For cross-validation with perpetuity method
Best Practice: Calculate terminal value using BOTH methods and compare. If they're vastly different, re-examine your assumptions.

Common Terminal Value Mistakes

Excessive Growth Rates

Using 5%+ terminal growth rates is almost never justified. No company can grow faster than the economy forever. Stick to 2-3% max.

Forgetting to Discount Terminal Value

Terminal value is calculated at Year 5 (or final year). You must discount it to present value using (1+WACC)^5 to add to enterprise value.

Terminal Value > 90% of Total Value

If terminal value represents 90%+ of enterprise value, your projection period is too short or your explicit forecasts are too conservative.

Ignoring Margin Normalization

In terminal year, margins should reflect sustainable long-term levels, not peak or trough levels. Normalize margins before calculating terminal FCF.

Sensitivity Analysis for Terminal Value

Given terminal value's large impact, always run sensitivity analysis:

Example Sensitivity Table (Base Case: g=2.5%, WACC=10%)

Growth Rate WACC 9% WACC 10% WACC 11%
2.0% $7,321M $6,375M $5,667M
2.5% $7,885M $6,833M $6,029M
3.0% $8,542M $7,357M $6,429M

Based on Year 5 FCF of $500M

Key Insight: A 0.5% change in terminal growth rate can change terminal value by 10%+. This is why terminal value assumptions require careful consideration and validation.

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