In a DCF valuation, terminal value (TV) is the present value of all cash flows expected after the end of the explicit forecast period. Because most DCFs use a 5–10 year explicit projection but assume the business operates indefinitely, terminal value typically accounts for 60–80% of the total enterprise value. That makes the assumptions behind it the single biggest driver of the answer.
Two standard methods
1. Gordon growth (perpetuity) method
$ TV_n = \frac{FCF_{n+1}}{r - g} $
Where FCFₙ₊₁ is the cash flow in the first year after the explicit forecast, r is the discount rate (WACC), and g is the perpetuity growth rate. The terminal value is then discounted back to today at WACC.
The g assumption is constrained by economic logic: in the long run, no business can grow faster than nominal GDP forever, so g is typically set in the 2–3% range for mature, developed-market businesses.
2. Exit-multiple method
$ TV_n = EBITDA_n \times \text{Exit multiple} $
The terminal-year EBITDA is multiplied by an exit multiple anchored to current trading or transaction comparables (see ebitda-multiple). The result is then discounted back at WACC.
Triangulation
Best practice is to compute both methods and cross-check them. Implied perpetuity growth from an exit-multiple DCF should be plausible (no double-digit growth into perpetuity); implied exit multiple from a Gordon-growth DCF should be near peer multiples. When the two diverge sharply, the explicit forecast or the assumed exit point is wrong.
Common errors
- Using a g that exceeds long-term GDP growth.
- Computing terminal cash flow off a non-steady-state year (e.g. a peak-of-cycle EBITDA).
- Forgetting to discount terminal value back to year zero.
- Mismatching nominal/real conventions (g and WACC must both be nominal or both real).
See also
- Discounted cash flow — An intrinsic valuation that discounts a company’s projected cash flows to present value.
- Weighted average cost of capital — The blended after-tax cost of a company's debt and equity capital, weighted by their proportions. The standard discount rate used in DCF valuations.
- Business valuation — The set of methods used to estimate the economic value of a company or its equity, almost always triangulated across several approaches into a defensible range.
- EBITDA multiple — The ratio of enterprise value to EBITDA, the most common shorthand for what a business is worth in M&A. Industry, scale, growth and quality of earnings all move it.