What you will learn
- Explain why a DCF needs a terminal value
- Calculate a terminal value using the perpetuity growth method
- Understand why the perpetual growth rate must stay modest
- Recognize that terminal value often dominates a DCF and must be stress-tested
A company does not stop generating cash at the end of your five or ten year forecast. It is assumed to keep operating indefinitely, a principle called the going concern assumption. The terminal value is how a DCF captures the worth of all those cash flows stretching beyond the explicit forecast period. It is the third ingredient, and for many companies it is the single largest piece of the answer.
What is terminal value? (Financial Edge Training)
A focused explainer on valuing the cash flows beyond the forecast. Watch how the two methods, perpetuity growth and exit multiple, both collapse the far future into one number.
The problem it solves
You cannot forecast individual cash flows forever, because the uncertainty would be absurd. So analysts forecast explicitly for a manageable horizon and then collapse everything after that into one figure, the terminal value. It represents the value, at the end of the forecast period, of all remaining future cash flows. That terminal value is then itself discounted back to today, just like any other future amount.
Key terms
- Terminal value
- The value of all cash flows beyond the explicit forecast period, captured in a single figure.
- Perpetuity growth method
- Assumes cash flow grows at a small constant rate forever. Also called the Gordon growth method.
- Perpetual growth rate (g)
- The modest forever-growth rate, usually near long-run economic growth, around 2 to 3 percent.
- Exit multiple method
- Estimates terminal value by applying a market multiple to a final-year metric, as if the business were sold.
Method one: perpetuity growth
The perpetuity growth method, also called the Gordon growth method, assumes the company's free cash flow grows at a small, constant rate forever after the forecast period. The terminal value equals the final year's cash flow, grown one year, divided by the discount rate minus the perpetual growth rate. In symbols, that is final cash flow times (1 plus g), divided by (WACC minus g). The logic is the math of a growing perpetuity, the same idea behind the dividend discount model you will meet shortly.
Terminal value by perpetuity growth
In the final forecast year a company produces 100 of free cash flow. You assume it grows at 2.5 percent forever after that, and your discount rate is 10 percent. What is the terminal value?
- Grow the final cash flow one year. 100 times (1 plus 0.025) is 102.5.
- Divide by the rate minus the growth. Divide by (0.10 minus 0.025), which is 0.075.
- Solve. 102.5 divided by 0.075 is about 1,367.
Why it matters: Notice how large this is compared to a single year's 100 of cash flow. That is why terminal value often dominates a DCF, and it still has to be discounted back to today.
Calculate a terminal value
A company's final forecast year free cash flow is 120. You assume perpetual growth of 2 percent and use a discount rate of 8 percent. What is the terminal value? Round to the nearest whole number.
The discipline on the growth rate
The perpetual growth rate g must be modest. A company cannot grow faster than the overall economy forever, because if it did, it would eventually become larger than the entire economy, which is impossible. So g is usually set near the long-run rate of economic growth or inflation, often in the region of 2 to 3 percent. Using a high perpetual growth rate is one of the most common ways to accidentally, or deliberately, inflate a valuation.
Nothing grows faster than the economy forever. A perpetual growth rate above a few percent is a red flag, not a forecast.
Spot the inflated terminal value
An analyst's DCF uses a perpetual growth rate of 8 percent forever in the terminal value. Why should this worry you?
A perpetual growth rate of 8 percent implies the company eventually becomes larger than the entire economy, which is impossible. It inflates the terminal value and the whole valuation.Method two: exit multiple
The alternative is the exit multiple method, which estimates terminal value by applying a valuation multiple, such as EV divided by EBITDA, to the company's metric in the final forecast year, as if the business were sold then at a typical market multiple. This grounds the terminal value in observable market pricing rather than an assumed growth rate. Many analysts compute both methods and check that they give broadly consistent answers.
Terminal value (Aswath Damodaran)
The authority's take on terminal value and the assumptions behind it. A little advanced, so focus on why terminal value is so important and so easy to abuse.
Why terminal value deserves caution
In a typical DCF, the terminal value often accounts for the majority of the total estimated value, frequently 60 to 80 percent of it. That means most of your valuation rests on assumptions about a period you did not forecast in detail, and on inputs, the perpetual growth rate and the discount rate, to which the result is extremely sensitive. This is not a reason to distrust the DCF, but it is a strong reason to stress-test the terminal value and to treat any DCF output as a range rather than a single confident number.
Where does most of the value come from?
If the terminal value makes up 70 percent of a DCF's total value, what does that mean for how carefully you should treat its assumptions, and why?
Write an answer before comparing it with the model response.
Model answer
It means most of the valuation depends on a period I did not forecast in detail, resting mainly on the perpetual growth rate and the discount rate. Because the result is so sensitive to those two inputs, I should stress-test them, try a range of values, and treat the final number as a band rather than a precise figure. The bulk of the answer is riding on the assumptions I am least sure about.
You now have all three ingredients. The next lesson assembles them into a complete valuation, step by step, so the whole process becomes concrete.