Fundamental analysisModule 6, lesson 32 of 48
Terminal value
How the perpetuity growth and exit multiple methods estimate terminal value, why it is often most of a DCF, and the sensible limits on long-run growth.
In this lesson
- Calculate terminal value with the perpetuity growth method and the exit multiple method.
- Explain why terminal value often makes up most of a DCF valuation.
- Set a sensible long-run growth rate and explain why it cannot exceed the economy's growth for ever.
- Cross-check the two methods against each other.
Builds on
- Discounted cash flow valuationTerminal value is the last building block of the DCF explained there.
On this page
In simple terms
A DCF forecasts cash flows year by year for a limited period, often five or ten years. But a healthy business keeps going long after that. The terminal value captures the value of all the cash flows beyond the forecast period in a single number, measured at the end of the period and then discounted back to today like any other cash flow.
Because it covers everything from the end of the forecast onwards, the terminal value is usually the largest part of a DCF. In the DCF lesson's example it was about 78% of the total.
The perpetuity growth method
This method assumes that after the forecast period, free cash flow grows at a constant rate for ever. The value of such a stream is:
terminal value = final-year cash flow × (1 + g) ÷ (WACC − g)
g = long-run growth rate, which must be below WACC
This is sometimes called the Gordon growth model. It is simple, but very sensitive to g and WACC, because the denominator, WACC minus g, is a small number.
Worked example: How long-run growth changes the answer
Using the DCF lesson's made-up company: final-year free cash flow of ₹160 crore and WACC of 11%.
| g = 3%: 160 × 1.03 ÷ 0.08 | terminal value ₹2,060 crore |
|---|---|
| g = 5%: 160 × 1.05 ÷ 0.06 | terminal value ₹2,800 crore |
| g = 7%: 160 × 1.07 ÷ 0.04 | terminal value ₹4,280 crore |
Moving long-run growth from 3% to 7% roughly doubles the terminal value. Discounted to today, the gap between the two is about ₹1,300 crore, against an enterprise value of about ₹2,100 crore in the 5% base case.
Limits on long-run growth
No company can grow faster than the economy for ever. If it did, it would eventually become larger than the whole economy. So the long-run growth rate should be at or below the economy's expected long-run growth in nominal terms, including inflation. Many analysts use a rate a little below that.
Growth must be below the discount rate. If g equals or exceeds WACC, the formula breaks down and gives an infinite or negative value, which is a sign the assumptions are wrong.
Growth needs investment. Free cash flow in the terminal period must reflect the reinvestment needed to achieve the assumed growth. A company that earns a return of R on new investment must reinvest roughly g ÷ R of its after-tax operating profit to grow at g, as the incremental returns lesson explains. Assuming high growth with little reinvestment overstates value.
The exit multiple method
Instead of a perpetual growth formula, this method assumes the business could be sold at the end of the forecast period at a typical valuation multiple:
terminal value = final-year EBITDA (or earnings) × an assumed multiple
It is grounded in how the market values businesses, but it quietly imports today's market multiples into a long-term valuation. If today's multiples are high, so is the terminal value.
Cross-checking the two methods
Each method can be used to test the other.
Worked example: Implied growth from an exit multiple
Suppose the made-up company's final-year EBITDA is ₹300 crore and an analyst applies an EV/EBITDA multiple of 10, giving a terminal value of ₹3,000 crore. With final-year free cash flow of ₹160 crore and WACC of 11%, what perpetual growth does that imply?
| Implied g = (TV × WACC − FCF) ÷ (TV + FCF) = (3,000 × 0.11 − 160) ÷ (3,000 + 160) | about 5.4% |
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If 5.4% a year for ever seems too high for this business, the exit multiple is too generous.
Similarly, a perpetuity growth terminal value can be divided by final-year EBITDA to see what multiple it implies, and compared with what similar companies trade at.
Why it matters
Because terminal value dominates most DCFs, getting it wrong means getting the whole valuation wrong. Many over-optimistic valuations rest not on unrealistic near-term forecasts but on an aggressive long-run growth rate or exit multiple. Checking the terminal value is the single most useful test of any DCF.
Limitations
Assuming any business grows steadily for ever is a simplification. Some businesses will decline or disappear; others will grow faster for longer than a five-year forecast captures, which is why some analysts use longer forecasts or a middle stage with fading growth. The exit multiple method depends on market conditions at the time of the valuation.
Common mistakes
- Using a long-run growth rate above the economy's.
- Forgetting to discount the terminal value back to today.
- Assuming high growth without the matching reinvestment.
- Using today's high multiples as exit multiples without checking the growth they imply.
Try it yourself
- Take the DCF you started in the previous lesson.
- Calculate the terminal value at long-run growth rates of 3%, 4% and 5%, and the share of total value it represents in each case.
- Calculate what EV/EBITDA multiple each terminal value implies, and compare with peers' multiples.
- Decide which growth rate you can defend, and write down why.
Key takeaways
- Terminal value is the value of all cash flows after the explicit forecast period, measured at the end of that period and then discounted to today.
- The perpetuity growth method assumes cash flows grow at a steady rate for ever. The exit multiple method applies a valuation multiple to the final year.
- Terminal value is often 60% to 80% or more of a DCF, so small changes in its assumptions move the whole valuation.
- No company can grow faster than the economy for ever. Long-run growth should be at or below the economy's expected long-run nominal growth.
- The long-run growth rate must be below the discount rate, and growth must be consistent with the reinvestment needed to achieve it.
Check your understanding
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Terms used in this lesson
- Terminal value
- In a DCF, the value of all cash flows after the explicit forecast period, often the largest part of the valuation.
- Discounted cash flow
- A valuation method that estimates a business's worth as the present value of the free cash flow it will generate.
- WACC
- The average return required by all of a company's providers of capital, weighting the cost of equity and the after-tax cost of debt.
- EV/EBITDA
- Enterprise value divided by EBITDA, a valuation multiple that compares companies with different debt and depreciation fairly.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.