How it works
There are two common ways to estimate it. The perpetual growth method assumes cash flow grows at a steady rate forever. The exit multiple method assumes the business could be sold at the end of the forecast for a multiple of its earnings, such as EV/EBITDA.
Terminal value is often more than half of total DCF value, so it deserves a sanity check. The growth rate should be modest, in line with long-run inflation or economic growth in the relevant currency. The implied exit multiple should be believable next to similar businesses.
Perpetual growth: TV = Final-year free cash flow × (1 + g) ÷ (r − g)
Exit multiple: TV = Final-year EBITDA × Multiple
A simple example
How it is used
- Completing a DCF valuation.
- Testing whether a forecast depends too heavily on the distant future.
- Cross-checking a growth-based value against a multiple-based value.
Common mistakes
- Setting growth above the long-run growth of the economy.
- Using a discount rate that is not higher than the growth rate. The formula breaks down.
- Forgetting to discount the terminal value back to today.
- Applying a multiple from a boom period.
Questions
What growth rate should I use for terminal value?
A rate at or below long-run inflation or expected nominal growth in the currency of the cash flows. Many analysts use between 2% and 4%, but the right rate depends on the currency and the market.
Why is terminal value so large in a DCF?
Because a business is expected to keep earning cash long after the forecast ends, and those cash flows add up to a large amount even after discounting.
Keep learning
- What is a DCF (discounted cash flow)?
- What is WACC (weighted average cost of capital)?
- What are valuation multiples (EV/EBITDA, P/E)?
- Guide: Business valuation
- Damodaran: EV/EBITDA multiples by sector
- Glossary: Terminal value
- Glossary: Terminal growth rate (perpetual growth rate)
- Glossary: Discounted cash flow (DCF)
- Glossary: EV/EBITDA